2016 Outlook – a peak at the year ahead

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As we approach the end of what has been a hectic year in the markets it is worth taking a step back to consider what could be install for the next 12 months or so. Here we will discuss some of the key themes that we are expecting to dominate 2016.

Policy divergence remains they key theme for 2016

A strong domestic economy is expected to lift US GDP growth to 2.8% in 2016. This growth, along with a pick up in the labour market, should result in a rise in inflation more generally. The Federal Reserve is expected to raise interest rates for the first time in nearly 10 years by 0.25% on 16th December 2015. Further rate rises, albeit at a graduate rate, are expected next year and we are looking for two further 0.25% increases to 1% by the end of next year.

In contrast, in the Eurozone, although forecast to rise by 1.8% in 2016, economic growth should continue to underperform the US. The European Central Bank cut its deposit rate to a record low of -0.30% on 3rd December 2015 and have extended the duration of its asset purchase programme to “March 2017 or beyond if necessary”.

Similarly, over in Japan, a weak inflation outlook means that further monetary policy stimulus next year remains on the cards.
In the UK, the private sector is expected to continue to drive the economy which is expected to expand by 2.3% next year. Inflation is likely to rise at a gradual pace and the potential for a rise in global commodity prices, along with stronger domestic price pressures, should push inflation closer to the 2% target towards the end of 2016 and in to 2017. The Monetary Policy Committee’s rhetoric is biased towards gradual interest rate rises but the policy makers do have room to delay this until much later next year. Assuming growth and inflation move broadly as expected, policy rates are forecast to be raised just once in 2016 by 0.25% to 0.75%

Is the oil price set for a bounce?

The continuation of the low oil price has pushed down inflation rates across economies for much longer than expected. The outlook remains uncertain but the weakness does look set to continue for the short term. Further down the line, however, some of the supply factors that have pushed the oil price lower may subside whilst global economic prospects are expected to improve.

This therefore has the potential to result in stronger global inflation which should remove deflation fears and potentially change central bank policy decisions.

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Outlook for emerging markets remains mixed

India is anticipated to be the outperformer among major emerging market economies in 2016 despite political factors relating to the government’s ability to push through structural reforms through the upper house which is dominated by opposition parties.

In China, the pace of expansion is expected to ease further to 6.3% in 2016. This represents a gradual slowdown from the strong growth in past years as the economy shifts towards services and domestic consumption.

In Russia, the potential for a rise in commodity prices should provide some relief to their economy and huge economic and political challenges stay in Brazil where they are expected to remain in recession.

High debt levels risk to the outlook

World debt levels have continued to rise since the end of the financial crisis and this suggests that there is little or no room for fiscal policy to provide significant economic stimulus.

In emerging markets debt levels have increased significantly and this poses a downside risk to emerging market currencies and therefore the global economy in general.

Other risks and increased market volatility

There are a number of other potential risks to the global economy that could transpire throughout 2016.

The main geopolitical risk being that of further destabilisation in the Middle East which could impact on the refugee crisis in Europe and also create more tension between Russia and the West.

Here in the UK, the timing and outcome of the EU referendum remains a potential source of uncertainty and could cause some volatility in the markets, especially if the polls are close leading up to the vote. The referendum is due before the end of 2017 but could be held next year to avoid a clash with French and German elections.

In the US, the start of interest rate rises for the first time in almost 10 years could also have the potential to cause volatility especially if the Federal Reserve’s intentions have been misinterpreted by the markets. Finally, the US presidential election also takes place in November 2016.

More generally, the uncertainty of the global economic outlook and policy response from central banks could keep volatility high in the financial markets.

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So what does that mean for currencies?

The start of US interest rate rises is expected to result in further upward pressure on the US Dollar in the first half of 2016 and the US policy stance contrasts with the likelihood of further stimulus in the Eurozone and Japan with a delay in UK rate rises expected until the second half of the year.

Therefore, the markets are likely to focus on the pace of interest rate rises and any hints that the pace may deviate from ‘gradual’ could have a significant impact.

Overall we look for EUR/USD to weaken towards parity by mid-2016 and GBP/USD is forecast to fall towards 1.4 before rising again after the start of interest rate increases in the UK.

The US Dollar is expected to weaken in the second half of 2016 with the EUR/USD therefore likely to head back towards 1.10 by the end of the year and the GBP/USD back towards 1.50 over the same period.

The USD/JPY is expect to rise to 130 but then fall back towards the 125 area before the end of next year.
In terms of the emerging markets, given what we have previously said, we are looking for continued weakness in the Brazilian Real and upside for the Indian Rupee.