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Presidential election years without an incumbent running have tended to be associated with a small decline in equity prices. We do not see the election as having much impact on the trajectory of Fed policy.  At most, the Fed may want to avoid action at the 2 November 2016 FOMC meeting, which does not include updated economic forecasts, nor is it followed by a press conference.

There are several factors that make this cycle unique and arguably, even more, challenging than would normally be the case.  Lower nominal GDP means that interest rates will be below levels that prevailed in previous cycles.  The Federal Reserve has new tools, like interest on excess reserves and scaled-up reverse repos that have not been battle-tested. 

Unlike past cycles, the Federal Reserve has set a target range for Fed funds rather than a fixed point target.  It is not clear where Fed funds will trade relative to its range.  We have argued that to maximize the effectiveness of its new tools, the Fed may want to provide sufficient liquidity to keep the effective Fed funds rate (weighted average) somewhat below the mid-point of the range.  That would also help officials drive home the point that rate increases will be gradual.     

The Fed’s balance sheet is also in play in a way it was not in past cycles.  An estimated $220 bln of US Treasuries the Fed owns may mature in 2016.  It cannot be expected to allow the full amount to roll-off, but maybe around mid-year, the Fed may begin exploring this tool.  Letting some fraction mature and/or refrain from reinvesting interest payments would be seen as providing a tightening impulse.

Europe

• Immigration challenge may be more concerning than Greece.

• The UK’s EU membership could occur in the second quarter; the risk of rejection may lead to an underperformance of sterling and UK assets.

• We continue to expect that the Bank of England will be the next major central bank to hike rates.

The immigration/refugee challenge may reach existential proportions.  In some ways, it is more fundamental than Greece, which preoccupied investors at the start of 2015.   As we have seen in the debt crisis, EU officials are pushing for new collective powers that erode national sovereignty.  The goal is enhanced ability to protect the external borders, even over the objection of national officials.  The politically salient agenda of immigration, terrorism, high levels of unemployment, economic insecurity, and sovereignty, plays into the hands of demagogues. 

It is not clear when the UK will hold a referendum on its membership in the EU.   Many expect it late in the second quarter of 2016.  The UK has long seen its interest extended in joining Continental initiatives.  Membership gave an opportunity to shape directions and outcomes.  The expansion of the EU eastward has provided the UK new support for some of its positions.

If the UK does opt to exit, we would expect sterling and UK assets, in general, to be marked down, and potentially sharply (depending on what had been discounted).  However, in the end, we expect that the UK will remain in the EU.

The Bank of England is widely perceived to be the second of the G7 central banks to hike rates after the Federal Reserve.  A hike in the late first-half of 2016 seems a reasonable time frame.  However, wage growth, one of the few arguments favoring a hike, has already lost the upward momentum, and there are other signs that the UK economy may be slowing.  The risk seems to be toward a later rather than a sooner BOE lift-off.

Easing monetary policy in December takes the ECB out of the picture in Q1 16.  But if there is little improvement in inflation prospects nearer midyear, and if the euro remains resilient and oil heavy, then the doves may push for more action. Unlike previously, though it did not prove to be the case, Draghi did not indicate that the -30 bp deposit rate exhausts interest rate policy.  Fiscal policy also looks to be less restrictive in 2016 than it has looked to be the case until late 2015.

China

• As China transitions to a services and consumption focused economy, officials recognize the need for more flexible prices for money.

• The close link between the yuan and the dollar injects an unwanted tightening impulse in the rising dollar environment  that  we  anticipate.

• There is a significant change in the market now that China is experiencing capital outflows, yet China should not use this as a pretense to devalue, and then re-link to the dollar when the greenback’s cycle turns.

The world’s second-largest economy is engaged in a multi-faceted transition.  Partly driven by its desires of its political elite, and in part driven by competitive pressures, China is moving up the value-added production chain:  It is shifting from manufacturing to services, and investment (debt) to consumption.

To facilitate this transformation, Chinese officials seem to recognize the need for more flexible prices for money.  This necessitated the liberalization of money market rates and greater flexibility of its monetary policy.  This in turn requires the loosening of the link between the yuan and the dollar.

This is wholly desirable and necessary.  The divergence theme is not only about Europe and Japan, but China too.  The cyclical pressures in China will likely prompt further easing from the PBOC.  The close link between the yuan and the dollar injects an unwanted tightening impulse in the rising dollar environment that we anticipate.

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