Five developments (apart from China) to monitor in 2016

by Michael Collins, Investment Commentator at Fidelity

January 2016

Angela Merkel enters the New Year as the political colossus holding Europe together. She’s even the “Chancellor of the Free World”, as TIME magazine put it after making her “Person of the Year” for 2015,[1] something the Financial Times also did.[2] In her 11th year in power as German chancellor, the leader of the centre-right Christian Democratic Union has kept the German economy afloat over the global financial crisis and the eurozone debt crisis – Europe’s largest economy is 15% bigger today than when she took power in 2005. Among Merkel’s feats to appease the German electorate, the doctorate in physical chemistry has preserved the euro, imposed austerity on spendthrift neighbours, sacrificed Cyprus as a lesson to others and won games of brinkmanship with Greece. But now close to a majority of Germans want Merkel gone. Rather than inspiring awe, Merkel is triggering growing protests in Germany, revolts within her cabinet and undermining by her finance minister.

The drop in support for Merkel and her conservative coalition is mainly due to Berlin’s decision last year to accept more than one million refugees, about 1.5% of Germany’s population, a choice that her Finance Minister Wolfgang Schaeuble likened to an avalanche started by “a careless skier”.[3] About 48% of respondents to an Emnid poll for the Bild newspaper published on December 2 said they don’t want Merkel to serve another term from 2017. That result topped the 46% who said they did. (The other 6% were undecided.)

While Merkel has erred during her time as chancellor – austerity has imposed deflation on the eurozone, her dithering has resulted in crisis after crisis that still leaves the euro’s future uncertain, and she has done little to revamp Germany’s export-dependent economic model – such results should worry investors. A centrist and pragmatist, who has such trust of investors that a recent cover of The Economist described her as the “indispensable European”, is vulnerable. A leader who was unassailable in the middle of last year could easily decide not to contest the elections next year.[4] The populist forces swirling within Germany that would gain more traction if Merkel is weakened could be less accommodating to European interests. These hardliners would stop the European Central Bank’s quantitative-easing program, expel Greece from the euro given the chance and even pull Germany out of the common currency. Five state elections in Germany throughout 2016 will probably provide the best indication of Merkel’s likely fate.

Merkel’s political fortune is just one of the political and economic developments that could upend the core presumptions that investors are making as 2016 begins. The consensus is that Europe will keep muddling through its crisis intact and that, as tempting as it might be to leave, the UK will stay in the EU. Other conventional views are that the US economy can withstand higher interest rates and that the Federal Reserve won’t raise the US cash rate by too much too soon. Other widely held opinions are that inflation will stay tame, centrist politicians will win elections in key advanced countries, especially the US, that independence movements in advanced countries will go nowhere and that China’s economy will muddle through. 

To be sure, the consensus views may prove largely true. Merkel, for instance, faces no obvious challenger, her party is still ahead in the polls and, to diffuse the refugee issue, she’s promised to reduce the immigrant intake. So why worry? It’s true too that it’s unforeseeable – even incomprehensible – events that often cause the most problems anyway. Just think of the consequences of political turmoil in China, a cyber-attack freezing global finance or Isis taking control of major oil fields in the Middle East. And there could even be nice surprises. US consumers are happy with the unpredicted plunge in oil prices and their better mood is good for the world economy. But most of the time the biggest concerns aren’t shocks. They were already well underway. There are plenty of developments already in train that could prove watersheds for the world economy and global markets. Even if just one of them happens, other widely held assumptions could be in jeopardy.

Rising populists

One sobering thought for investors is that this time next year the world could be preparing for the inauguration of President Donald Trump (one of five people TIME shortlisted for Person of the Year).[5] This is possible because the demagogue has led Republican polling for six months and he sometimes beats presumed Democrat nominee Hillary Clinton on match-ups.[6] No matter how outrageous are his comments on Mexicans, Muslims, immigrants, women or the disabled or how stupid or absent are his policies, Trump appears immune from damage. In fact, the more Trump is slammed by the political elite and mainstream media, the more popular he becomes. While common sense says that Trump won’t prevail due to the moderate nature of most voters, that’s no solace. Someone else will exploit the viral populism that is raging in the US, fuelled by inequality, insecurities spawned by globalisation, social upheaval, polarised politics, the fear of terrorism and concerns that the US is waning as a world power. Even if Trump fades away, he has already damaged US politics. To name but two ways, firstly, he has pushed the Republican Party to the fringe. The second is that he makes other dangerous populists look reasonable – even those who want to put the US dollar back to the gold standard, restrict the Federal Reserve’s power to change monetary policy or even, in some instances, abolish the Fed.

Across the Atlantic, politics is even more troubling for investors because populists are already grasping power and shaping policy. The seven-year-and-counting depression in the eurozone is nourishing anti-elite populist nationalistic parties that generally reside on the right side of politics. In 2015 in national or state elections in Austria, Denmark, Finland, France, Italy, Poland, Switzerland and the UK, anti-immigration, nationalistic right-wing parties achieved the biggest gains and sometimes made or helped form national governments (Finland, Poland and Switzerland). In other elections, anti-austerity leftist governments came to power in Greece and Portugal and the emergence of a leftist, anti-austerity and another more-centrist party cost Spain’s ruling pro-austerity right-wing party its parliamentary majority, left parliament paralysed and is likely to lead to a fresh election in coming months. Noteworthy too is that a Danish referendum unexpectedly rejected closer EU integration on justice legislation, an unelectable leftist populist (Jeremy Corbyn) became leader of the UK’s Labour Party, secessionist movements persisted in Catalan and Scotland, the UK’s push to leave the EU gained strength and Hungary’s right-wing government became more autocratic. The immigration crisis and the terrorist attacks in Paris in November prompted countries including Denmark and Sweden to reintroduce border controls and in the case of Hungary and Slovakia to build border fences. Basically the political consequences of economic hardship, spiced with terrorism, are remaking Europe to the disadvantage of investors.

While the UK vote on EU membership is to be watched as it’s now deadlocked,[7] perhaps the biggest menace to monitor is Marine Le Pen’s National Front. In the first round of voting in French regional elections in December, the anti-immigration, anti-EU but pro-welfare-state party came first in six of the 13 regions and won the largest share of the national vote (28%). The party failed to win any provinces in the second round but this might be to its advantage – governing is the antidote for populist parties for it usually exposes them as charlatans and fools. Le Pen’s goal is to win France’s presidential elections in 2017 and the polls say she will make it to the second round of two contenders and lose. It would prove devastating for the eurozone if such a nationalist and protectionist were to win. Le Pen presents almost all the ills of France as being tied to the euro. She has pledged to make reintroducing the franc her top priority, a decision that could shatter the EU as well as the eurozone.

US rates where?

Back in the US, Fed Vice Chair Stanley Fischer recently said that the pace of any US rate hikes would probably be more akin to a “crawling” than a “lift-off”.[8] Fischer was speaking in June, six months before the Fed on December 16 raised the US cash rate from the zero to 0.25%. Investors will need to monitor the US economy to see how Fischer’s prediction is faring.

What’s unusual about the talk on the outlook for the US cash rate is how polarised views are. While there are many who back Fischer’s general view that the US cash rate could rise to 1.5% by the end of 2016 and to 3% by the end of 2018, many think US rates could rise higher and faster than expected because prices are drifting higher. Inflation could become a concern, they say, because consumer spending is buoyant, wages are expected to expand at a reasonable pace now the jobless rate has halved from its post-crisis peak of 10% in 2009 and rental and medical expenses are rising. The UK-based Capital Economics, for instance, forecasts the US cash rate to reach 3.5% by 2017. Such predictions, if they come to fruition, would cause ructions to a fragile world economy.[9]

The opposite line of thinking expects the Fed to join the list of blundering central banks – one that includes the Reserve Bank of Australia and the ECB – that raised rates after the global financial crisis only to soon cut them again. A survey in December by The Wall Street Journal of 65 economists founds that 58% of those who responded said it was “somewhat or very likely” the US cash rate will be back near zero within five years.[10] Worryingly, 10 said the Fed might even make its deposit rate negative as the ECB and other central banks have done. These pessimists see that a foreign shock, tame inflation, a financial crisis or the petering out of the recovery could force the Fed to backtrack.

In the US, Australia and elsewhere, motorists are relishing cheaper petrol, which gives them more money to spend on other items. Commodity- and oil-importers such as the eurozone, China, Japan and India are enjoying healthier trade balances from the drop in prices.

But the collapse in the price of coal, copper, oil, iron ore and other commodities due mainly to China’s slowing has repercussions that need to be monitored (as does China’s slowdown too). For starters, the plunge in commodities entrench deflationary forces in the eurozone and Japan, which could see their policymakers turn to more radical steps to revive their economies. Other concerns are that oil-producing and commodity-exporting countries are facing a hit to trade balances, government budgets and consumer spending. Countries such as Brazil, Chile, Colombia, Russia and Venezuela are being buffeted by the plunge in commodities at a time when the prospect of higher US interest rates is hoovering capital from these countries, undermining their currencies and boosting repayments on the US$4.5 trillion (A$6.2 trillion) of US-dollar-denominated debt that emerging countries owe. A development to look for is the political instability that usually pairs with economic hardship. Even Saudi Arabia’s stability could be tested – many experts have long seen it only a matter of time anyway before the Al Saud dynasty’s grip on power weakens, opinions that have gained more notice in recent weeks.

Advanced countries that rely on commodities are not immune either. In the US, some high-yield funds that invested in shale-linked bonds have stopped returning cash to investors after being swamped by demands by clients for their money, raising concerns about a 2008-style upheaval on credit markets. Australia’s fate is more straightforward. The RBA’s commodity price index has more than halved from its peak in mid-2011.[11] That battering to Australian living standards is felt via reduced mining earnings, lower wages, a falling currency and restricted government services (or higher debt and increased pressure on interest rates if authorities fail to adjust their spending to match the decline in tax receipts, which means lower-than-otherwise future living standards). Perhaps Australians might be overly caught up with developments at home to worry too much about what’s happening to Merkel and others in foreign lands.

Financial information comes from Bloomberg unless stated otherwise.