In some ways this is going to be a watershed year. Many commentators started the year thinking many developed economies would return to the more familiar territory of at least steady economic growth (except in the Eurozone and Japan) and policymakers would return to the once-familiar quandary as to how far and how fast to put up interest rates in order to fend off the danger of inflation.

However the first two weeks of 2016 have seen a severe Chinese stock market sell-off which has sparked carnage across global financial markets. Equity indices in Japan and Europe have lost a 10th of their value in the first two weeks of 2016 with the US not far behind.

Which theme will dominate this year? A continuation of a China inspired global financial market depression or modest growth in China and the rest of the global economy leading a recovery in equity and commodity markets and talk of higher global interest rates.

Commodities

A hugely significant influence on the world economy will continue to be the price of oil which starts the year at $37 per barrel. Oil has slumped by more than 70 per cent since July 2014, when prices hit $115 per barrel.The drop was precipitated by OPEC’s landmark decision to flood the world’s markets by maintaining production in the face of falling prices. In 2016 it is likely the oil price will stay around current levels, although it’s possible it might trend up a little.

It is also likely, with sentiment and market positioning towards commodities extremely negative, that 2016 will see periodic short price spikes upwards. At the start of the year we have seen such a commodity spike upward from oil prices, to US cattle futures to iron ore. However, the overall oil price trend is not strong as the world is awash with supply, with OPEC in complete disagreement on any production limits, and Saudi Arabia seeking to continue to put pressure on higher cost US shale gas producers; a policy which seems to be working if taking longer than expected.

Two consequences follow: Firstly, across pretty much all of the developed world the rate of inflation is set to rise from near-zero rates. Such an uptick in inflation will occur as, even if oil prices remain at current levels, the energy drag on the broad inflation measures (year-over-year) will diminish as time moves on. Secondly, whereas last year saw the predominance of the negative effects of low energy prices over the positive ones, this year that balance should reverse. The losers from low prices will already have done most of their cutting, think BP and Shell, while the gainers may still increase their spending.

China

China is unlikely to provide the main source of anxiety this year although it was the catalyst for early New Year global stock markets falls. I suspect that the slowdown has pretty much ended and there may even be scope for economic growth to pick up a bit. However in the past month, warnings signs have been flashing red as the renminbi has weakened against a basket of currencies rather than just the dollar. What are some of the reasons behind this urgency to devalue? While the fiscal stimulus has been helpful in preventing a “ hard landing”, apparently it’s not enough to stabilise growth. The nation’s manufacturing sector continues to contract.

A sharply weaker renminbi could have damaging consequences for other emerging market countries and the world economy,which an overly “hawkish” (interest rate raising) and US – centric Fed (see below) could make worse.

US

The recovery should move along at its solid, though unspectacular, pace. 2015 was dominated by speculation over when the Federal Reserve would raise interest rates. There is every reason to expect this to continue. The Fed is indicating to the market (by Fed Governor predictions) that there will be four rises of 0.25 percentage points. The market expectation, derived from the Fed Funds futures market, is for two rises. The market is driven by the expectations that US growth and inflation will remain tepid. This gap will have to be reconciled in 2016.

Over the longer term, the Fed’s median forecast suggest rates will rise to 3.25 % at the end of 2018, with market expectations (determined by tradable futures contracts today) predicting a full percentage point lower. The market may turn out to be wrong or the Fed could change its forecasts, but some investors worry that Janet Yellen, chairman of the Federal Reserve, and the Fed itself, are on course to make the hawkish mistake of raising rates too quickly, which could tip the world into recession.   

US Equities

The US market was a lot less volatile than its European peers in 2015 and the S&P 500* ended almost even for the year. However, if it had not been for a small group of nifty companies 2015 would have been a bad year for US stocks. The market needs to thank a group of four companies that come to be known as “Fangs”- Facebook, Amazon, Netflix, and Google – and for a slightly wider group that adds Microsoft, Salesforce, eBay, Starbucks and Priceline to create the “Nifty Nine”. Both groups gained more than 60 per cent during last year.

Such a “narrowing” of the market is a classic symptom of a lengthy rally (this one has lasted almost uninterrupted since 2009) that is coming to an end. However, the US economy looks reasonably robust with the services sector expanding but at a lower rate. The focus this year therefore will be on the consumer to drive economic growth with more ‘money in his pocket’ as petrol, and energy prices generally, remain weak. However, it is quite likely to be another flat year for most US stocks with, at the same time, little risk of any recession for market to worry about.

*The S&P 500 is an equal-weighted index where each of the 500 companies receives 0.2 per cent of the index.    

 

Europe

Turning to the Eurozone, the area’s economic recovery is likely to continue in 2016. In particular, improvements in credit expansion, as a result of the current and extensive Quantitative Easing programme take effect, should provide tailwinds for growth. Political uncertainty however continues to pose risks. From Spain to Finland (as “Fixit” becomes an increasingly heard word), the concerns are likely to persist this year.

In recent years, the Eurozone has been a running sore for the world economy.Although it did better last year, I suspect that its growth rate will fall back in 2016.

European Equities

The German DAX was the best performer of the major European indices, finishing 2015 up 11%.Whilst the DAX performance is creditable we should remember that in April of 2015 it was up nearly 30%, highlighting how difficult the second half of the year was. Analysts expect Germany to continue its strength as the industrial based economy benefits from a low oil price and the continued weakness of the Euro. Other European stock markets should also enjoy some of this benefit.

 

UK

I do not expect the Bank of England to follow the Fed’s lead quickly but I do expect it to follow before very long. UK growth is expected to hit 2.9 per cent this year, the second fastest growth in the G7 after the United States.The economy is 6.1 per cent larger than its pre-financial crisis peak. Furthermore, as inflation rises over the next few months and more attention paid to the distortions caused by over-loose monetary policy, the pressure will build for higher interest rates.

Admittedly, I don’t expect them to reach more than about 1 pc by the end of the year, but after these seven long years of rates held at the record low of 0.5 pc, even this small increase is going to be felt keenly. Over recent months I have become increasingly aware that many people, both financial experts and ordinary punters, have come to believe that ultra-low interest rates are here to stay for an extended period. They will be in for a shock.  

Despite the prospect of higher interest rates and continued fiscal tightening, the UK economic outlook looks pretty good. I expect wages to rise as the employment rate increases, allowing real income to increase so helping inflation rise to the 2 pc target.

The coming referendum on the UK membership of the EU could have serious economic consequences. We still don’t know the date of the referendum and so this creates uncertainty which markets do not like. The pound could be forced lower as people worry about an “out” vote but this would in fact help UK overseas trade and reduce the large UK current account deficit. It would be ironic if fears of the adverse economic consequences of an EU exit delivered the UK a massive boost to its competitiveness via a weaker currency, causing both the overall rate and the balance of economic growth to improve!

UK Equities

The UK market, as measured by the FTSE 100, has been one of Europe’s worst performers, falling around 5% in 2015, largely due to its high exposure to metals, mining, oil and gas, some of the worst hit sectors. With the outlook for such sectors fairly muted it is hard to see the index coming close to its all time high of 7,122.74 reached on 27th April 2015 when commodity prices were significantly higher.

Emerging Markets

It is likely a number of Emerging Market commodity producing nations will continue to struggle with high levels of inflation after the unprecedented declines in their currencies e.g. Zambia inflation went from 7.5% (year-on-year) to 21% at the end of 2015.Venezuela’s inflation rate, to the extent it can be measured, is out of control as the government debt default looms.

Two other emerging economies that remain highly vulnerable this year are Brazil and South Africa. Brazil has certainly been caught in the EM turmoil, its equity market fell 14% in 2015 and its currency, the real , has fallen 44% against the US dollar.

Worth noting that volatility in Emerging Markets particularly hit those fund managers focussed on this sector with Aberdeen Asset Management in the UK and Franklin Templeton in the US seeing significant client fund outflows.  

 

Foreign Exchange

Two themes dominated 2015. Firstly, the significant falls in Emerging Market currencies as commodity prices plummeted; EM countries are big commodity exporters. Secondly, a strengthening US Dollar supported by relatively robust US economic growth and a rising interest rate regime; the only developed country to be raising interest rates.   

Will 2016 see the Eurozone’s embattled currency be worth less than a US Dollar for the first time in more than 13 years. The single currency (currently 1 Euro = USD 1.08) depreciated heavily throughout 2014 and sold off again last year amid a worsening of the economic outlook for the Euro area and the introduction of further monetary stimulus by the European Central bank (ECB). If ECB policymakers add stimulus to the Euro area yet again, downward pressure on the Euro will likely follow.  

Japan

A number of analysts project that Japan’s core inflation will rise this year but barely break above 1% by 2017.The Bank of Japan’s inflation target remains elusive meaning more Quantitative Easing could be on the way. But the Nikkei stock market rose 10% in 2015 on optimism over the current loose monetary policy approach.