AllianzGI Insights - January 2016

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Volume 8, Issue 1
Allianz Global Investors
Insights
January 2016
Global View
5 Good and 5 Bad Scenarios for 2016
At the beginning of every year, many of our
clients think about market-moving events
that could materialise over the next 12
months – all of which are possible and none
of which are certain. With the perspective
of a full year in front of us, we will assess
how ten scenarios – five good and five
bad – could play out for investors in 2016.
The good
1. Russia rehabs relationship with EU
Russia could be coaxed back into a stronger
relationship with the European Union,
reducing trade tensions and sanctions.
Economic activity and investment would
then return to Eastern Europe and to key
industrial segments such as energy and
consumption. Tensions surrounding
Ukraine would subside, allowing the economy to stabilise, supported by a strong 2016
harvest. Further out, geopolitical tensions
could fall in “Syraq” as the United Nations
becomes more focused and effective in
fighting the Islamic State, permitting supply
pressures on oil to fall further – perhaps
below USD 20 per barrel, thereby boosting
economic activity globally.
2. Rising local wages
Inflation in urban areas could remain robust
in 2016, leading to growing evidence of
sustainable domestic inflation globally,
which would then begin to support rising
local wages. Growing political backing for
an increase in minimum wages would add
further support. While global goods prices
may fall because of overproduction and
high inventories, domestic cost-push
inflation could help drive wage increases
and momentum in consumer spending. If
the depletion gap in oil production tightens
supply in 2016, inflation might settle within
the desired range of the world’s central
banks. This would provide an optimum
environment for financial repression to
work, favoring equities over bonds in 2016.
3. Further European integration
The journey to the “United States of Europe”
may well make further progress in 2016 as
Neil Dwane
Global Strategist
EU policy promotes further industry and
market consolidation, spreading out from
telecommunications and media to the retail,
service and insurance sectors. Preparations
for MiFID 2 (Markets in Financial Instruments Directive 2) could lead to changes in
the advisory, savings and pensions landscapes across Europe, as banks and asset
managers try to anticipate changes in client
behaviours. Regional and international
companies might become increasingly
attracted to the consolidation opportunities
in Europe, leading to further outperformance for the region’s equities.
(Continued on page 2)
2 Perspective on the US
High Yield: Value Amid Volatility
3 Viewpoint
What’s Missing in the Debate About
Thomas Piketty?
Allianz Global Investors Insights
(Continued from page 1)
4. China begins to rebalance economy
China’s economic growth might start
rebalancing as the next five-year plan is
implemented and the banking industry
modernizes. The big Chinese banks will
continue to protect the ageing state-owned
enterprises while new banking entrants, like
Alibaba, deploy savings and capital to the
new consumer and service markets. The
“one belt, one road” policy is increasingly
allowing China’s excess productive capacity
to be used more efficiently. And with the
International Monetary Fund’s SDR (supplemental drawing right) inclusion, China will
be able to rebalance its own national savings surpluses and flows more constructively. This rebalancing would allow Asian economies to respond with domestic initiatives
to restore growth throughout the region
during 2016, further buttressed by economic rejuvenation in India and Indonesia.
5. Short tightening cycle by the Fed
After a brief period of interest-rate hikes, the
US Federal Reserve may stand pat ahead of
the US presidential election. Holders of long
positions on the USD might begin to capitulate, causing the currency to weaken during
2016. This would curtail the headwinds facing most emerging markets and allow commodity prices to rise, further releasing the
fiscal pressures on commodity-exposed
economies. With the European Central Bank
and Bank of Japan still active in markets, the
global economy could receive a liquidity
burst that causes global equities to generate
double-digit returns!
The bad
1. Rise in Europe’s real interest rates
Despite the ECB’s monetary policy and negative interest rates in the euro zone, we
could actually see an increase in the real
interest rates charged to European consumers, as happened in Switzerland in 2015.
This would depress access to credit and hurt
the economy. The latest ECB transparency
report reveals that euro-zone banks are
earning 10 to 20 per cent of their profits
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from the LTRO (long-term refinancing operation) carry trade, which will fall in coming
quarters as ECB quantitative easing drives
out returns. Falling earnings and increased
regulatory capital requirements look to further dampen performance for bank shareholders in 2016.
investment and growth opportunities for
the global economy. With governments
squeezing out the private sector from
investment, investors might seek to leave
the credit markets but find themselves
caught with low levels of liquidity, which
would generate poor pricing and volatility.
2. Capital investment falls
Capital expenditure and investment plans
may drop across the world in 2016 as China
rebalances, while excess manufacturing
production and exports could exacerbate
global pricing difficulties. This would cause
more capacity closures and diminish maintenance operational expenditures, all within
a global economy with high inventory-tosales ratios, leading to decreasing industrial
production throughout the year. Many
emerging-market countries, including
Brazil and South Africa, could slip into a
vicious vortex of declining fiscal revenues
and increasing political crises, adding to
growing headline volatility from politics
and geopolitics.
5. Global pandemic appears
Super strains of antibiotic-resistant bugs
could appear throughout the world’s health
care systems, leading to plague-like illnesses akin to those of the Middle Ages. With
the global population mostly over-exposed
to antibiotics , there would be no natural
defence to these bugs, especially since the
pharmaceutical industry has allocated few
new resources to finding new antibiotics.
Travel and leisure could then be affected by
rolling outbreaks of older traditional illnesses like tuberculosis and diptheria, as well as
new Ebola-type infections.
3. Middle East becomes messier
Turkey could become even more embroiled
in the Syraq disaster, resulting in local
nationalism from the Kurds and other
local groups exacerbating the “wars on
the ground”. Egypt, too, may experience
more political and social stress from both
African migration and Islamic militancy,
bringing the hawks in Israel to the fore
and raising geopolitical tensions near the
breaking point. Oil supply shocks would
then occur, with prices spiking above USD
100 per barrel, causing the global economy
to fall into a recession.
4. Two-tier credit market
Corporate credit markets might start to
tighten further as central-bank policy divergence continues during the first half of 2016.
This would create a two-tier market for
credit as strong mega caps access markets
easily while weaker emerging-market countries and troubled sectors like mining, retail
and oil are pushed out, further depressing
Allianz Global Investors Insights
Perspective on the US
High Yield: Value Amid Volatility
Trading in bear territory since the fall of
2014, high-yield bonds have experienced
growing market pressures ever since,
making 2015 one of the most volatile years
in the history of the asset class. The 2008
financial crisis aside, the performance of the
past year was the worst for an annual period
outside of 2000. Furthermore, and
uncharacteristically, high-yield bonds in
2015 delivered their first negative annual
return outside of an economic recession.
One-two punch: Commodities and
regulation
The previously mentioned market
pressures can be narrowed down to two
distinct causes:
◾◾ declines in energy and materials
prices; and
◾◾ broker-dealer inventory changes and bank regulations.
The high-yield sector’s commodity-related
exposure and the significant declines in oil,
natural gas and metals prices have been
well-documented. In addition, brokerdealer and bank market-making – or the
lack thereof, caused by government
regulations and the desire to reduce risk
exposure – has resulted in inefficient
transfer pricing. The market-smoothing
mechanism that broker-dealers and banks
once brought to the table is no longer
present in today’s market. Consequently,
small trades can have a big impact on prices.
Not another 2008
Despite the gloom present at the beginning
of this year, we don’t believe 2016 will be a
repeat of 2008. Back then, the financial
crisis was rooted in leverage that linked
back to the banking system through
subprime mortgage-backed securities
and other vehicles/instruments such as
CDOs (collateralised debt obligations),
SIVs (structured investment vehicles) and
CDSs (credit default swaps). The banking
system in 2008 was exposed to each new
layer of leverage, and on top of that, the
amount of leverage in the system was
significant. Today, the banking system is
much less leveraged, substantially more
regulated and better understood. In
addition, broker-dealer balance sheets are
much smaller and inventory leves, which
have declined, are minimal.
Doug Forsyth
CIO US Income & Growth Strategies
Highest yields in 5 years
Given the extreme volatility levels recently
present in the marketplace, the short-term
forecast for high-yield bonds is less clear
and future conditions remain under scrutiny.
However, at 9 per cent, high-yield bonds
are offering their highest yields since 2011.
Correspondingly, spreads have widened
out to 700 basis points over comparable
Treasuries. Defaults will rise, but the market
has priced in a higher-than-likely realized
rate. If the US economy continues on a
moderate growth path and avoids recession,
the high-yield market looks to offer
considerable value in 2016.
Viewpoint
What’s Missing in the Debate About
Thomas Piketty?
The theories famously presented in Thomas
Piketty’s Capital in the Twenty First Century
can be summarily boiled down to:
“Whoever owns capital accumulates ever
more of it, and the widening wage gap
further exacerbates this concentration”.
But is this necessarily a capitalist law of
nature, as Piketty asserts, or is he ultimately
introducing a different debate that should
have been addressed ages ago: how to
unite labour and capital without one
hurting the other?
Income and inequality
Piketty’s chain of argument comes
complete with an inequality formula: r > g.
The r is return generated on capital that is
greater than total economic growth, or g.
According to Piketty, the interaction of
these two fundamental components of
capitalism results in inequality, which is
further exacerbated by the growing shift
away from labour income toward capital
income. Here, Piketty sees growing signs of
dual inequality in terms of wages and
capital ownership.
Hans-Jörg Naumer
Global Head of Capital Markets & Thematic Research
The answer is equity ownership
Although the discussions surrounding the
theories voiced by the French economist
have been extremely diverse, one key
(Continued on page 4)
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Allianz Global Investors Insights
(Continued from page 3)
question is not being asked: If capitalism,
defined as an economic model that is based
on private ownership and subject to the
laws of a market economy, truly is capable of
producing prosperity, and if the challenge is
to counter the concentration of capital
without abolishing capitalism, then why not
eliminate the divide between labour and
capital via equity ownership? This aspect
seems to be missing in the debate about
Piketty’s theories. Although Piketty suggests
a few reforms – including a global tax on
wealth – he ignores the option of equity
ownership by wage earners.
Where income comes from
Income can be generally understood to
mean earnings from both labour and
investments. Ultimately, however, it is
irrelevant which type of earnings make up
total income in an economy. During periods
of major demographic and technological
change in particular, focusing less on this
distinction would be an effective means of
preventing the further concentration of
labour income and capital that Piketty fears.
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Understand. Act. This two-word philosophy is at the core
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then act decisively to deliver solutions. We are a diversified
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Investing involves risk. The value of an investment and
the income from it will fluctuate and investors may not
get back the principal invested. Past performance is not
indicative of future performance. Equities have tended
to be volatile, and unlike bonds do not offer a fixed rate of
return. Emerging markets may be more volatile, less
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values may fluctuate with currency exchange rates.
Bond prices will normally decline as interest rates rise.
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The income side of total economic added
value offers some hints about the declining
importance of labour vs. capital income.
The percentage of US gross domestic
product contributed by wages and salaries
dropped from around 50 per cent in the
1970s to around 41 per cent by the middle of
the decade, according to the US Department
of Commerce’s Bureau of Economic Analysis.
Or, to put it another way, if you analyse the
income side of GDP, the share contributed
by capital income has grown to around 60
per cent. Significantly more than one US
dollar out of every two generated as income
accrues to owners of capital. The trend in
Europe differs from one country to the next,
but a shift away from earned income and
towards investment income can also be
seen there.
the workforce is shrinking because of babyboomer retirement, advanced robotics and
automation could fill the void. Why not let
machines do the work for humans and,
consequently, replace or supplement wages
and pensions with investment income?
Creating a more highly automated and
advanced economy would solve several
problems at once: a declining workforce,
machines displacing humans from the
remaining jobs, and the issues caused by
concentration of capital and declining
income. Eventually, human employees
would become the owners of capital.
That should be the first choice and final
answer in the debate about inequality. So
why not support capital formation in the
hands of the workforce by investing savings
in equities?
Robots to the rescue
Apart from equity ownership’s importance
in being able to participate in capital
income, it also helps society cope with vast
demographic and technological changes. If
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