Macro Outlook

The dollar, Crude & China: The Trinity

Important factors to watch out in 2016 would be dollar, China and crude oil – though not necessarily in the same order. A strong dollar has a deflationary effect on commodity exporters – most global exports being largely denominated
in dollars and in extension to the rest of the world. A further dollar rally could intensify deflationary forces at work and curb growth. China, in my opinion is a bigger impending obstacle to a global recovery. China is slowing down rapidly
and taking a large bite out of global GDP growth. Investors are realizing this and capital is fleeing China fast. We saw Chinese equities trading being suspended earlier this week after hitting consecutive circuit breakers & Chinese authorities starting to police the nation’s foreign exchange market in a way currency traders have rarely seen before.

China has spent a lot of forex to support the Yuan in the last 6 months. If Beijing buckles under pressure and further accelerates the Yuan’s depreciation, it will trigger another round of competitive depreciation by exporters triggering deflationary pressures. In October 2014, I had written about a black swan event lurking around – a possible devaluation of the Chinese Yuan which actually happened in August 2015 (https://www.tatamutualfund.com/docs/other-documents/cio-newsletter-vol-002.pdf). The natural state of the world is
deflationary, due to demographics, technology and debt. This is the outcome central banks fear most. Deflation increases the real value of debt and accelerates defaults. We’re already seeing this in energy and other junk debt. As per Standard & Poor’s, corporate defaults rose to the highest level since 2009
with 107 globally this year and 40% of them in the oil & gas or metal and mining sectors.

The Dollar, China & crude trinity will be the key determinant of global economic health and liquidity going forward. The collapse of crude oil and in extension, petro dollars has changed a lot of parameters in the global liquidity equation.
Oil producers (most of their economies are pretty much dependent on oil exports) are adjusting to the new reality of lower oil prices – low enough to ensure budget deficits on some of these economies for the first time in recent memory.

The result – initiate spending cuts or dip into sovereign wealth funds to make up for the lower revenues in order to keep the capex going. Sovereign funds, fuelled by energy and petro dollars have bought treasury, commodity assets, real estate,
stakes in companies in the last 15 years. With these buyers coming to the market to sell some of these hard-to-trade assets, liquidity will be a victim, thats for sure. The shortage of dollars is threatening to choke off erstwhile easy access
to dollar debt. EM economies and high dollar-leveraged corporates are the most vulnerable. A paradox has emerged in the financial markets where although unconventional monetary policies have created a massive overhang of liquidity, but a series of recent shocks suggests that macro liquidity has become linked with severe market illiquidity! Liquidity is a coward – it runs away from you when you need it the most. Watch out for global liquidity (or rather the lack of it?) going into 2016.

Disclaimer: The views expressed in this article are personal in nature. It do not construe to be any investment, legal or taxation advice. Any action taken by the reader or recipient on the basis of the information contained herein is reader’s/recipient’s responsibility alone and Tata Asset Management Limited will not be liable in any manner for the consequences of such action taken by reader / recipient.

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