January 6, 2017

News in Charts: What a year. How did we do?

by Fathom Consulting

2016 was a momentous year. Many famous and much-loved individuals died — making it feel like the end of an era. Rank outsiders recorded historic sporting victories — making it feel like we were experiencing some generalised ‘tail-event’ in the sporting world. Major political upsets occurred with alarming regularity — making it feel as though perhaps the tide has turned decisively away from the settlement of the last fifty years or so, at least in the developed world. It feels as though anything is possible.


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Looking ahead, the outlook for the global economy hinges to a great extent on the turning of the political tide. Indeed, if that process continues unabated through 2017, we will be in a very different world, politically and economically, by the end of the year. If other countries swell the rising tide of isolationism and protectionism, it will be profoundly damaging for global growth, through a reduction in global trade via tariffs and other barriers (as the chart illustrates), and a corresponding reduction in the gains from comparative advantage. But if that tide has already reached its flood, and starts to ebb in coming months, then it will be closer to business as usual, with some important nuances and wrinkles around that, including a decisive ‘decoupling’ between the US and other developed economies – to be discussed in our forthcoming Global Economic and Markets Outlook.

All of our calls in the coming year will be coloured and informed by our assessment of this underlying issue, along with the other consistent strands of analysis that run through the Fathom view. We do not make individual calls ‘out of the blue’ – instead, they all flow from a coherent analytical position which we convey to clients in our quarterly presentations and regular newsletters. Good calls reinforce our underlying view; bad calls challenge it.

Looking back on 2016, we made a number of good calls, based on our analysis, ahead of the market and the consensus, and a few less-good calls too. Here is a brief summary of Fathom’s performance in retrospect in 2016.

Our 2016 top six best calls (in the sense that they were different from the consensus at the time, and later proved to be correct) were as follows (in no particular order):

  1. China would reverse the downwards trajectory of its growth by throwing in the towel on rebalancing towards consumption and, instead, ‘doubling down’ on financing further accumulation of manufacturing, infrastructure and real estate investment. The ramifications of that would include:
    1. Continued falls in the value of RMB against the dollar
    2. Stabilisation and then modest increases in oil and other commodity prices
    3. Increasing debt and banking / shadow banking risk in China
  2. The US economy would continue to grow strongly even with a Trump victory, implying:
    1. The dollar would strengthen whatever the outcome of the Election
    2. The Fed would raise rates
    3. A related good call was to identify, ahead of the consensus, the relationship between Mr Trump’s popularity (and subsequent victory) and the value of the Mexican peso
  3. The global focus of macroeconomic policy would shift from monetary to fiscal stimulus, led by China. Relatedly:
    1. NIRP would prove damaging for the banks
    2. Low rates are doing more harm than good
  4. The threat of global isolationism would grow, thanks to declining real wages across the developed world, partly thanks to globalisation.
  5. The impact of a Trump victory would probably be positive for US growth and equity markets.
  6. The EA banking sector is structurally flawed, especially in Italy, thanks to the unresolved accumulation of peripheral sovereign debt.
    1. Germany would outperform the periphery thanks to its relatively low debt and strong competitive position

Our two least-good calls were as follows:

  1. We were unduly pessimistic about the short-term impact of the Brexit vote on growth in the UK (albeit not as pessimistic as the Bank of England, the Treasury or the consensus).
  2. At the start of the year, we called for Chinese policy rates to fall sharply and to end 2016 below the US policy rate (which we expected to rise more rapidly than it did). This has not happened, as the focus shifted to fiscal rather than monetary stimulus in China, as we subsequently predicted.

Those calls in detail

China and the Renminbi. Last year we detected a change of course in Beijing, as officials threw in the towel on rebalancing and began to ‘double down’. A weaker RMB, we argued, would be part and parcel of this. We were right, on both fronts. Our own measure of China’s economic activity (our CMI) rose to 2.9% in October — the highest reading since August 2015, and the fifth consecutive month that the CMI has risen. This pick-up has been primarily driven by those indicators most closely related to China’s old growth model. In April, we forecast a 4.0% effective depreciation, and a move in CNYUSD to 6.75, by the end of 2016.  China’s currency has tracked our forecast closely, though if anything it has fallen a little faster, particularly against the US dollar.

In both our central and risk scenarios for 2017 the policy of growth through investment and net trade continues. However, in the latter scenario, as globalisation is thrown into reverse and China’s dependence on exports is laid bare, its policymakers have little option but to quicken the pace at which they allow the renminbi to depreciate.


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In our Global Economic and Markets Outlook for 2016 Q2 we said “if the CMI (Fathom’s proprietary China Momentum Indicator) is set to turn, expect to see stronger commodities prices, particularly metals and therefore… a resurgent China is good for commodities exporters, and will provide a much-needed boost to non-core inflation around the world.” The price of Brent crude oil rose by around 50% last year alongside a pick-up in the CMI.


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Also, as a consequence of doubling down, we said that China would succeed in kicking the can down the road. It has done so, but only at the cost of aggravating existing problems of excessive debt, excessive bank and shadow-bank leverage, and excess capacity in infrastructure, real estate and manufacturing – issues that we illustrated in our estimate of NPLs in the Chinese banking and shadow banking system.

Bullish on US growth after the Election. We were ahead of the market and the consensus in arguing that a Trump victory would probably be good for US growth, at least in the short term (and for as long as the rest of the world did not contribute to the tide of protectionism, a scenario we called “Donald Dark”) – a view that has subsequently become part of the consensus. We also put the chances of a Trump victory at 50% ahead of the Election – substantially higher than the pollsters or the bookies’ odds had it at the time.


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Bullish on the dollar. Our main conviction call before the US election was that the US dollar would rise no matter what the outcome in the medium term. Part of that was because we continued to be bullish on the Fed funds rate. Fathom has been calling for a Fed rate hike during 2016 for many years. For the first half of 2016, that was a consensus call. But we reiterated it during June (right after the Brexit vote) at a time when it was strongly non-consensus, and the market-implied probability was zero. This is what we said the day after the UK voted to leave:

“Federal funds futures prices seem to be implying that the US economy is heading into a recession. We disagree. In fact, we still believe that the domestic economy is relatively strong and that the labour market is close to full employment. We anticipate a pick-up in wage growth, pushing both core and headline inflation higher this year and next. On that basis we still believe that there is a realistic prospect of one US rate rise this year, probably in December, with several more to come next year.”


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Trump and the peso. Fathom was among the first to identify the relationship between Mr Trump’s popularity and the value of the Mexican peso (intuitively, the peso responding to the threat of tariffs under a Trump administration). We wrote about this in August and discussed it with clients before that.


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Shift from monetary to fiscal policy. Last year, we speculated that it was the “end of the road for monetary policy” in advanced economies. Recognising that prolonged use of emergency monetary policy had held back growth in productive potential, we suggested that fiscal policy would be better suited to the task in hand. With a growing public awareness that the emphasis on monetary policy to restore economic growth was wrong-headed, we predicted that as the year progressed we would see a migration towards the top left of our chart. Since then, the policy mix has begun to shift with China leading the way, followed by Japan and the US, as we predicted.


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Damaging effects of NIRP. Back in March, we highlighted the pitfalls of Negative Interest Rate Policy (NIRP), suggesting that the BoJ should reverse course, saying:

“Worse still, central banks are now lowering interest rates into negative territory even though evidence suggests that negative interest rate policy could be damaging to growth. Indeed, financial institutions have demonstrated a reluctance to impose negative rates on retail deposits, meaning that the policy either hurts banks’ profitability or leads to higher lending rates. Both are perverse outcomes.”

Since then, Japan’s economic performance has continued to disappoint, and investors have punished Japanese banks (until recently – the reversal is thanks to the falling value of the yen against the dollar after Mr Trump’s victory).


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Low rates damaging productivity. We have been arguing since the end of 2015 that the global low interest rate environment is damaging to productivity growth, since they suppress the forces of creative destruction that are central to innovation in the long run, resulting in creeping ‘zombification’ of the corporate and banking sectors, and encourage ever more saving into assets that provide ever-decreasing returns. Since then, many other respected economists have been coming round to our view.

Rising threat of global isolationism. Fathom was early in drawing attention to the underlying economic drivers of the disaffection with globalisation in developed economies – citing the famous chart of global income growth by income percentile initiated by Branco Milanovic: the chart of 2016.


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Structural flaws in the EA. We have been long-term bears in relation to euro area banks. Some equities are cheap for a reason, and EA bank equities are among those. We reiterated that call just before the Brexit referendum, arguing that weak EA banks will be some of the first casualities of the uncertainty about the future of the European project engendered by Brexit – and specifically about the future of the ‘ECB put’ option implicitly enjoyed by holders of peripheral sovereign debt in the euro area.  Since then, a sequence of events have contributed further to that uncertainty: the Brexit vote, Trump’s election victory, the ‘no’ vote in Italy’s referendum. And there could be more to come during 2017.


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German outperformance. Fathom has argued for many years that the dominant factor driving long-term trends in global growth and divergences across countries is debt. Thirty years ago and more, the biggest problem in the developed world was inflation and how to control it. For the next thirty years, it will be debt and how to control that. One manifestation of that view was that we expected that Germany would continue to outperform the euro area as a whole, and particularly the periphery, as it has not built up nearly as much debt as have its peripheral counterparts – at least for as long as the bad assets in the periphery are not counted on the German government balance sheet – watch this space…

Too pessimistic about Brexit. We did not foresee the Brexit vote, though we judged the likelihood of Brexit to be higher than the pre-referendum odds had it, being among the first to attribute that to a global tide of populism and anti-globalisation. But our central case was Remain. In that central case, we expected UK growth to slow between 2016 and 2017 – our consistent position since the start of 2016 and earlier.

But the UK’s surprise vote to leave the EU in June caused us to revise down our forecasts for growth in both years. Since then, data has surprised on the upside – business surveys rebounded after their initial collapse and even early business investment data were surprisingly buoyant. This led us to shift our growth forecast back up, at least part of the way. Our current view is that the negative impact of Brexit, specifically via investment, is still to come – we will explain why in our forthcoming Global Economic and Markets Outlook.


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Policy rate convergence. Our policy rate forecasts made in our Global Economic and Markets Outlook for 2016 Q1 called for the Chinese policy rate to fall sharply, converging on the Bank of England policy rate and the Fed funds rate (and dipping below both by the end of 2018). This pattern has not materialised. There are two key reasons why: first, at the start of 2016, we did not predict the victory of Brexit and of Mr Trump, both of which pushed back UK and US rate hike timelines. Second, at the beginning of the year we thought China would attempt to boost its growth at least in part via monetary loosening, i.e. by cutting its lending rate and letting the RMB depreciate sharply. However, instead there has been a trend towards much looser fiscal policy in China – which we were early in identifying (see above), and the monetary loosening has not been as pronounced as we had expected as a result.


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