MARKET COMMENTARY

DECEMBER 2015
QUILTER CHEVIOT
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client an investment manager whose role is to design and implement an investment
strategy tailored to the needs of the client. A local presence and easy accessibility to
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Quilter Cheviot has a network of regional offices located in major cities in the UK,
Ireland and Jersey.

US and UK equities ended November

little changed with the S&P 500
at 2,080 and FTSE100 at 6,356.
Quantitative easing helped the
Nikkei 225 (up 664 to 19,747) and
the FTSEurofirst 300 (up 33 to 1,517)
make modest gains. In anticipation
of the first US interest rate rise in
mid-December, US shorter-dated
yields rose sharply although the 10year yield was unchanged reflecting
markets relaxed stance on inflation.
However, US high yield corporate
spreads - one of our key cyclical
indicators - widened again on signs
of weakening corporate balance
sheets taking the total year-to-

date to 100bp. In contrast, Bund

yields fell on expectations that the
European Central Bank would expand
its quantitative easing programme.
The dollar rose 4% against the
euro to 1.06 - a 13% gain year-todate - and 2% against sterling to
1.50. Commodities continued to
weaken and Brent crude closed at
$45. With OPEC having effectively
abandoned setting a production
target, further weakness seems likely.
The global economic outlook for
2016 is similar to this year. Growth of
around 2.5% is below the 3% norm
with downside risks for emerging

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economies vulnerable to higher

US rates and a stronger dollar.
Quantitative easing by central banks
will shape the deleveraging process
in the developed world but the
cost of servicing the debt burden
continues to limit the contribution that
governments can make to growth.
A key factor in 2015 has been the
slowdown in China - as the economy
adjusts to wasteful capital spending
and a self-inflicted asset bubble and its impact on the rest of Asia,
commodity producing countries and
global trade. The slow progress of
policy reform means there is limited
potential for a cyclical upturn during

MARKET COMMENTARY
Chinas structural transition to a
more sustainable growth rate while
GDP growth in many emerging
economies will be held back by
the level of debt built up since
the financial crisis. Trade and
manufacturing are therefore unlikely
to provide a significant boost to
the global economy in 2016.
Fortunately, consumers are in
robust health with disposable
household incomes benefitting
from minimal inflation, rising
employment and low interest
rates. In the US, fiscal policy and
oil market over-supply are also
supporting economic activity. The
drag from US fiscal tightening
- equivalent to 1.25% of GDP per
annum over the last five years - is
ending just in time to boost real
state and local spending by 3%
during the presidential election
year. Energy and metal price
declines are estimated to have
transferred the equivalent of 1%
of global GDP from producers to
consumers and, while the initial
reaction of US consumers was
muted, history suggests the process
still has some way to run. As US
housing starts have lagged the
population increase, construction
is likely to be a larger contributor
to GDP in 2016. Offsetting these
positives are higher interest rates
and the potential drag from
excessive dollar appreciation. After
a brief pause in the summer, payroll
employment has continued to grow
with the unemployment rate now
down to 5%. While visible slack in
the labour force - the gap between
the governments broad and
narrower unemployment measures
- has narrowed significantly in
recent months, the invisible slack
- such as hiring relative to job
openings - shows wage pressures
are limited and confined to lowpaying industries. Although the
Federal Reserve has signalled liftoff for interest rates in December,
their trajectory remains uncertain

given relatively subdued growth

and below target inflation which
may explain why financial markets
are anticipating a more benign
normalisation process than the
Feds own median projection.

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Exposure to China has weakened

the economic recovery in Japan
where exports are flat despite
yen depreciation. Additionally,
consumer spending has not
responded as expected to the
improvement in employment and
household incomes - this may
reflect the structural challenge
of an ageing population faced
with deteriorating purchasing
power. However, companies are
producing record profits helped
by the fall in corporate tax rates
and low levels of investment. While
government policies are designed
to tackle the key structural issues
of demographics, regulation
and inflexible labour markets,
the productivity revolution is
proving elusive and GDP growth
will struggle to recover to 0.7%
next year. Abenomics appears
to have reached another turning
point and, with core inflation
excluding energy still below
expectations, further quantitative
easing is likely in Q1 2016. A
potential upside surprise would
be an adjustment to corporate
tax policy aimed at kick-starting
investment and higher wages.
Disinflation and low growth also
feature in the eurozone although,
unlike Japan, there are signs of
improvement. Sub-par global
demand, especially from emerging
economies, is restraining recovery
but the Purchasing Managers
Manufacturing Index is at an 18
month high and rising domestic
demand coupled with modest
fiscal loosening should enable
GDP to rise from 1.5% this year
to 1.8% in 2016. To help things
along, the European Central Bank
has extended quantitative easing

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Source: Thomson Reuters Datastream 03/12/2015

MARKET COMMENTARY
and forced short-term market rates
deeper into negative territory - a
move unprecedented for a global
reserve currency. Peripheral countries
should grow faster than average if
they can avoid being derailed by
political discord, weak governments
and reform fatigue. Irelands growth
rate will slow to 5.5% but will still
be the highest in the developed
world. The uncontrolled increase
in inward migration presents a
structural challenge but may
focus attention on the economic
opportunity for a region with a
deteriorating demographic profile.
The pace of UK economic activity
is slowing but strong consumer
spending and housebuilding should
more than offset lower net trade and
tougher austerity to produce GDP
growth of 2.5% in 2016. Employment
and real disposable incomes are
rising but low inflation expectations,
increasing productivity, inward
migration and tighter benefit eligibility
mean that unit labour costs are
increasing by just 1% per annum.
Given the strength of sterling and
sub-par global growth, disinflationary
pressures are high and the first
interest rate rise has been pushed out
into 2017. Brexit is an obvious risk for
2016 and, although there is a long way
to go before the referendum result, we
are surprised how sanguine currency
and financial markets appear to be.

Against a background of modest

growth and very low inflation, central
bank policy divergence will add to the
challenges facing bond and equity
markets in 2016. The Federal Reserve
appears keen to expand its remit
beyond balancing growth and inflation
to normalising interest rates as part
of a broader commitment to financial
stability. This is happening just as the
European Central Bank and the Bank
of Japan are extending their policy
measures in the opposite direction.
The problem is that any further
dollar strength could not only choke
off US growth but also cause more
difficulties for emerging economies.
We expect short-dated bond yields to
rise more than longer-dated but both
moves will be modest until inflationary
pressures return. A low nominal GDP
environment means the corporate
sector faces another challenging
year and our focus will therefore
be on companies able to generate
surplus free cash flow and those
with strong balance sheets that are
able to grow dividends. Mergers and
acquisition activity is likely to increase.
Regionally, Japan and the eurozone
appear to offer the best scope for
re-rating albeit with some risk.

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