BH MACRO LIMITED – Monthly Shareholder Report – December 2015

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BH MACRO LIMITED - Monthly Shareholder Report - December 2015

BH MACRO LIMITED
MONTHLY SHAREHOLDER REPORT:
December 2015

YOUR ATTENTION IS DRAWN TO THE DISCLAIMER AT THE END OF THIS DOCUMENT

   

BH Macro Limited Overview
Manager:
Brevan Howard Capital Management LP (“BHCM”)
Administrator:
Northern Trust International Fund Administration Services (Guernsey) Limited (“Northern Trust”)
Corporate Broker:
J.P. Morgan Cazenove
Listings:
London Stock Exchange (Premium Listing)
NASDAQ Dubai - USD Class (Secondary listing)
Bermuda Stock Exchange (Secondary listing)		 BH Macro Limited (“BHM”) is a closed-ended investment company, registered and incorporated in Guernsey on 17 January 2007 (Registration Number: 46235).
BHM invests all of its assets (net of short-term working capital) in the ordinary shares of Brevan Howard Master Fund Limited (the “Fund”).
BHM was admitted to the Official List of the UK Listing Authority and to trading on the Main Market of the London Stock Exchange on 14 March 2007.
Total Assets: $1,495 mm¹
1. As at 31 December 2015 by BHM's administrator, Northern Trust.
Summary Information BH Macro Limited NAV per Share (as at 31 December 2015)
Share Class NAV (USD mm) NAV per Share
USD Shares 349.7 $20.33
EUR Shares 93.4 €20.56
GBP Shares 1,051.8 £21.21

BH Macro Limited NAV per Share % Monthly Change
USD Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD
2007 0.10 0.90 0.15 2.29 2.56 3.11 5.92 0.03 2.96 0.75 20.27
2008 9.89 6.70 -2.79 -2.48 0.77 2.75 1.13 0.75 -3.13 2.76 3.75 -0.68 20.32
2009 5.06 2.78 1.17 0.13 3.14 -0.86 1.36 0.71 1.55 1.07 0.37 0.37 18.04
2010 -0.27 -1.50 0.04 1.45 0.32 1.38 -2.01 1.21 1.50 -0.33 -0.33 -0.49 0.91
2011 0.65 0.53 0.75 0.49 0.55 -0.58 2.19 6.18 0.40 -0.76 1.68 -0.47 12.04
2012 0.90 0.25 -0.40 -0.43 -1.77 -2.23 2.36 1.02 1.99 -0.36 0.92 1.66 3.86
2013 1.01 2.32 0.34 3.45 -0.10 -3.05 -0.83 -1.55 0.03 -0.55 1.35 0.40 2.70
2014 -1.36 -1.10 -0.40 -0.81 -0.08 -0.06 0.85 0.01 3.96 -1.73 1.00 -0.05 0.11
2015 3.14 -0.60 0.36 -1.28 0.93 -1.01 0.32 -0.78 -0.64 -0.59 2.36 -3.48 -1.42
EUR Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD
2007 0.05 0.70 0.02 2.26 2.43 3.07 5.65 -0.08 2.85 0.69 18.95
2008 9.92 6.68 -2.62 -2.34 0.86 2.84 1.28 0.98 -3.30 2.79 3.91 -0.45 21.65
2009 5.38 2.67 1.32 0.14 3.12 -0.82 1.33 0.71 1.48 1.05 0.35 0.40 18.36
2010 -0.30 -1.52 0.03 1.48 0.37 1.39 -1.93 1.25 1.38 -0.35 -0.34 -0.46 0.93
2011 0.71 0.57 0.78 0.52 0.65 -0.49 2.31 6.29 0.42 -0.69 1.80 -0.54 12.84
2012 0.91 0.25 -0.39 -0.46 -1.89 -2.20 2.40 0.97 1.94 -0.38 0.90 1.63 3.63
2013 0.97 2.38 0.31 3.34 -0.10 -2.98 -0.82 -1.55 0.01 -0.53 1.34 0.37 2.62
2014 -1.40 -1.06 -0.44 -0.75 -0.16 -0.09 0.74 0.18 3.88 -1.80 0.94 -0.04 -0.11
2015 3.34 -0.61 0.40 -1.25 0.94 -0.94 0.28 -0.84 -0.67 -0.60 2.56 -3.22 -0.77
GBP Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD
2007 0.11 0.83 0.17 2.28 2.55 3.26 5.92 0.04 3.08 0.89 20.67
2008 10.18 6.86 -2.61 -2.33 0.95 2.91 1.33 1.21 -2.99 2.84 4.23 -0.67 23.25
2009 5.19 2.86 1.18 0.05 3.03 -0.90 1.36 0.66 1.55 1.02 0.40 0.40 18.00
2010 -0.23 -1.54 0.06 1.45 0.36 1.39 -1.96 1.23 1.42 -0.35 -0.30 -0.45 1.03
2011 0.66 0.52 0.78 0.51 0.59 -0.56 2.22 6.24 0.39 -0.73 1.71 -0.46 12.34
2012 0.90 0.27 -0.37 -0.41 -1.80 -2.19 2.38 1.01 1.95 -0.35 0.94 1.66 3.94
2013 1.03 2.43 0.40 3.42 -0.08 -2.95 -0.80 -1.51 0.06 -0.55 1.36 0.41 3.09
2014 -1.35 -1.10 -0.34 -0.91 -0.18 -0.09 0.82 0.04 4.29 -1.70 0.96 -0.04 0.26
2015 3.26 -0.58 0.38 -1.20 0.97 -0.93 0.37 -0.74 -0.63 -0.49 2.27 -3.39 -0.86
Source: Fund NAV data is provided by the administrator of the Fund, International Fund Services (Ireland) Limited. BHM NAV and NAV per Share data is provided by BHM’s administrator, Northern Trust. BHM NAV per Share % Monthly Change is calculated by BHCM.  BHM NAV data is unaudited and net of all investment management fees (2% annual management fee and 20% performance fee) and all other fees and expenses payable by BHM. In addition, the Fund is subject to an operational services fee of 50bps per annum.
NAV performance is provided for information purposes only. Shares in BHM do not necessarily trade at a price equal to the prevailing NAV per Share.
*Calculated by BHCM as at 31 December 2015
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS

   

ASC 820 Asset Valuation Categorisation* Brevan Howard Master Fund Limited
Unaudited estimates as at 31 December 2015
% of Gross Market Value*
Level 1 73.3
Level 2 26.2
Level 3 0.5
Source: BHCM
* These estimates are unaudited and have been calculated by BHCM using the same methodology as that used in the most recent audited financial statements of the Fund. These estimates are subject to change.
Level 1: This represents the level of assets in the portfolio which are priced using unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2: This represents the level of assets in the portfolio which are priced using either (i) quoted prices that are identical or similar in markets that are not active or (ii) model-derived valuations for which all significant inputs are observable, either directly or indirectly in active markets.
Level 3: This represents the level of assets in the portfolio which are priced or valued using inputs that are both significant to the fair value measurement and are not observable directly or indirectly in an active market.

   

Annual Manager Review: 2015























































Annual Performance Review: 2015




















Performance Review: December 2015


 

The NAV per share of the USD share class of BH Macro Limited depreciated by 1.42% in 2015, while the NAV per share of the Euro shares depreciated by 0.77% and the NAV per share of the Sterling shares depreciated by 0.86% in 2015. In aggregate, gains in FX trading were more than offset by losses in other areas. BH Macro Limited invests all of its assets (net of short-term working capital) in the ordinary shares of Brevan Howard Master Fund Limited (the “Fund”).

Our largest exposures at the start of the year were short positions in both the Swiss Franc and the Euro currencies, which were held in expectation of further ECB easing. The Fund successfully avoided the debacle caused by the Swiss National Bank unexpectedly de-pegging the Swiss Franc from the Euro in January, whilst profiting from the ECB’s subsequent quantitative easing (“QE”) announcement, to finish up approximately 3% at the end of Q1. Roughly half of these gains were given back in the second quarter as positions held in anticipation of an increase in market volatility due to the Greek crisis, which in the end was resolved, led to losses.

During the second half of the year we became increasingly convinced that the economic slowdown in Europe, and the likelihood that inflation expectations would start to decline substantially, would lead the ECB to ease much more aggressively than already elevated market expectations.  We consequently took large, highly convex positions to gain exposure to that view. In the event, the ECB disappointed the market at its December meeting and the gains we had made in November were negated by losses in December. Overall the view cost the Fund a little more than 1% over the two months. We knew that the amount of risk we took into the ECB December meeting was high, but our conviction was very strong and the Fund’s positions were structured in such a way that the potential gains on a positive outcome would have been far greater than the amount that was eventually lost in December. 

On the business side, the Fund’s team of investment professionals remained largely unchanged from the previous year with few arrivals and departures. Outside of the investment team, we rationalised the mid and back office functions at the end of the summer. This adjustment reflected the reduced number of Brevan Howard funds, consistent with a decision taken nearly two years ago to focus on our core macro strategies.

Looking forward, the central bank policy divergence that we have been anticipating for over a year has now finally arrived and I am confident that this will materially improve the opportunity set for us.

After 6 years at zero rates the Fed has started a hiking cycle, which means that every future FOMC policy decision will have some element of uncertainty. This is an important development for us as, for the first time in several years, there are two way trading opportunities on Federal Reserve decisions. At the same time, the zero bound for rates has been well and truly broken which means that the ECB, and the BOJ, amongst others, have room to further cut interest rates if they deem it necessary. In addition, the low volatility environment prevailing since the end of 2011 appears to have come to an end. The slowdown of global growth seems to be accelerating and disinflationary pressures appear to be intensifying. Should these trends continue, major central banks may in the future find it increasingly difficult to offer the level of support to capital markets that investors have come to expect.

The Fed took the crucial decision to begin the ‘exit’ from its policy of zero rates by enacting a first rate hike of 25bps at the end of 2015 with the declared intention to follow up with more increases in 2016. It would require the risk of a true crisis for them to reverse course quickly.

In the meantime the ECB, by deciding to disappoint market expectations at their December meeting, only to follow up with a rather more dovish press conference at the subsequent January meeting, seems to have fallen into a reactive mode. With price developments in the Eurozone continuing to undershoot both ECB and market expectations, the risks of fully fledged deflation have not gone away.

Finally, the PBoC is in the difficult position of having to balance a policy of smoothing an exchange rate depreciation, at the cost of a rapid erosion of foreign exchange reserves and a tight monetary policy stance, against the need to provide the monetary easing required by the economy and to allow for a non-disruptive de-leveraging process. The PBoC’s dilemma offers no comfort to global markets.  

Given this background, it is perhaps not surprising that capital markets have got off to a rocky start to 2016.

While we begin the year with very low levels of risk, I believe that some exceptional opportunities are likely to present themselves in this environment of regime shift and dislocation. We look forward to exploiting a rich opportunity set in the year ahead.

Yours sincerely,
Alan Howard

Performance by Asset Class


Rates		 Overall, the Fund’s performance in interest rate trading was negative. The majority of the losses came from directional and curve trading in USD interest rate markets. The Fund made gains in EUR directional and curve trading while trading in emerging market interest rates was a small detractor. Volatility strategies were also a small detractor overall.

FX		 The Fund’s performance in FX trading was positive, with most of the gains generated in the first quarter. The majority of the gains came from a general long USD theme against various currencies, in particular against the Euro. Trading in China FX also contributed positively in the third and fourth quarters. The Fund had an average FX exposure of approximately 50% of NAV, with more elevated levels of risk at the start and towards the end of the year.

Equity		 Overall, the Fund’s performance in equity trading was negative.  However, it started the year well with gains in Q1 from longs in European equity indices following the announcement of QE by the ECB.

Commodity		 The Fund's commodity risk in 2015 was low. The Fund suffered losses in precious metals and energy.

Credit		 The Fund made small losses in credit in 2015 mainly due to losses in corporate credit.

The information in this section has been provided to BHM by BHCM

The majority of losses in December resulted from positioning around the ECB meeting which was the same theme that had driven the gains in November. The bulk of the losses came from FX trading, but also from a combination of interest rate and equity index trading in Europe. FX trading losses came from short positions in the EUR; small offsetting gains came from China, SEK and CAD trading. Interest rate trading generated negative returns, with long positions in European interest rates being the main factor, only partially offset by gains from US directional and curve and basis trades. Equity trading was also a detractor; losses due to the weakness in European and Japanese equity indices outweighed the very small gains from US equity index shorts. Tactical long positions in energy incurred small losses.

Performance by Asset Class

Monthly, quarterly and annual contribution (%) to the performance of BHM USD Shares (net of fees and expenses) by asset class

2015 Rates FX Commodity Credit Equity Discount Management Total
January 2015 0.22 2.27 -0.01 0.00 0.62 0.04 3.14
February 2015 -0.09 -0.69 -0.10 0.01 0.28 0.00 -0.60
March 2015 -0.47 0.63 -0.05 0.14 0.11 0.00 0.36
April 2015 0.09 -1.31 -0.06 -0.02 0.02 0.00 -1.28
May 2015 0.41 0.61 0.01 -0.05 -0.05 0.00 0.93
June 2015 -0.01 -0.45 0.00 -0.11 -0.44 0.00 -1.01
July 2015 0.18 0.50 0.07 -0.05 -0.39 0.01 0.32
August 2015 -0.38 -0.08 -0.02 -0.05 -0.30 0.05 -0.78
September 2015 -0.03 -0.43 -0.05 -0.07 -0.11 0.05 -0.64
October 2015 0.08 -0.43 -0.08 -0.03 -0.21 0.08 -0.59
November 2015 0.30 2.09 -0.06 -0.03 -0.01 0.09 2.36
December 2015 -0.90 -2.15 -0.05 -0.04 -0.53 0.19 -3.48
Q1 2015 -0.34 2.21 -0.16 0.15 1.01 0.04 2.90
Q2 2015 0.48 -1.16 -0.05 -0.18 -0.46 0.00 -1.37
Q3 2015 -0.23 -0.02 -0.01 -0.17 -0.79 0.11 -1.10
Q4 2015 -0.53 -0.53 -0.19 -0.10 -0.75 0.35 -1.78
YTD 2015 -0.62 0.47 -0.40 -0.30 -1.01 0.50 -1.42

Monthly, quarter-to-date and year-to-date figures are calculated by BHCM as at 31 December 2015, based on total performance data for each period provided by the Fund's administrator, International Fund Services (Ireland) Limited. Figures rounded to two decimal places.

The performance attribution above is derived from data calculated by BHCM, based on total performance data provided by the Fund’s administrator, International Fund Services (Ireland) Limited and risk data, as at 31 December 2015.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

Monthly VaR of the Fund by asset class as a % of total VaR*

Rates Vega FX Equity Commodity Credit Total
January 2015 14 15 38 25 5 4 100
February 2015 16 12 26 39 1 5 100
March 2015 20 14 23 37 2 4 100
April 2015 21 12 29 29 2 7 100
May 2015 21 10 36 27 2 4 100
June 2015 30 16 26 20 2 5 100
July 2015 12 16 38 26 3 3 100
August 2015 37 16 31 9 3 4 100
September 2015 35 16 33 9 2 4 100
October 2015 34 11 41 7 4 3 100
November 2015 14 13 57 13 1 2 100
December 2015 39 11 25 14 4 7 100

Source: BHCM. Data as at 31 December 2015.

* Calculated using historical simulation based on 1 day, 95% confidence interval.

Performance by Strategy Group

Monthly, quarterly and annual contribution (%) to the performance of BHM USD Shares (net of fees and expenses) by strategy group

Macro Systematic Rates FX Equity Credit EMG Commodity Discount Management Total
January 2015 2.05 0.02 0.48 0.18 0.03 0.32 0.03 -0.01 0.04 3.14
February 2015 -0.44 -0.00 -0.12 -0.06 -0.01 -0.02 0.05 -0.00 0.00 -0.60
March 2015 0.06 0.00 0.31 0.02 0.02 0.09 -0.12 -0.00 0.00 0.36
April 2015 -0.75 -0.01 -0.39 -0.03 -0.01 -0.04 -0.04 -0.00 0.00 -1.28
May 2015 0.41 -0.00 0.45 0.10 -0.00 -0.03 -0.01 -0.00 0.00 0.93
June 2015 -0.83 -0.01 -0.08 0.02 0.00 -0.04 -0.07 -0.00 0.00 -1.01
July 2015 -0.02 0.01 0.42 -0.02 -0.01 -0.09 0.02 -0.00 0.01 0.32
August 2015 -0.57 -0.01 -0.22 0.00 0.01 -0.05 0.01 -0.00 0.05 -0.78
September 2015 -0.78 0.00 0.36 -0.06 0.00 -0.05 -0.17 -0.00 0.05 -0.64
October 2015 -0.39 -0.02 -0.28 0.05 0.01 -0.08 0.04 -0.00 0.08 -0.59
November 2015 2.00 0.01 0.18 0.16 -0.01 -0.06 -0.01 -0.00 0.08 2.36
December 2015 -2.94 -0.01 -0.32 -0.19 -0.00 -0.01 -0.19 -0.00 0.19 -3.48
Q1 2015 1.66 0.03 0.66 0.13 0.03 0.39 -0.04 -0.01 0.04 2.90
Q2 2015 -1.17 -0.03 -0.02 0.10 -0.00 -0.12 -0.12 -0.00 0.00 -1.37
Q3 2015 -1.37 0.00 0.56 -0.08 -0.00 -0.19 -0.14 -0.00 0.11 -1.10
Q4 2015 -1.39 -0.02 -0.42 0.03 -0.00 -0.15 -0.16 -0.00 0.35 -1.78
YTD 2015 -2.28 -0.01 0.79 0.17 0.02 -0.07 -0.45 -0.01 0.50 -1.42

Monthly, quarter-to-date and year-to-date figures are calculated by BHCM as at 31 December 2015, based on total performance data for each period provided by the Fund's administrator, International Fund Services (Ireland) Limited. Figures rounded to two decimal places.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

Methodology and Definition of Monthly Contribution to Performance:

Attribution is approximate and has been derived by allocating each trader book in the Fund to a single category. In cases where a trader book has activity in more than one category, the most relevant category has been selected.

The above strategies are categorised as follows:

“Macro”: multi-asset global markets, mainly directional (for the Fund, the majority of risk in this category is in rates)

“Rates”: developed interest rates markets

“FX”: global FX forwards and options

“EMG”: global emerging markets

“Equity”: global equity markets including indices and other derivatives

“Commodity”: liquid commodity futures and options

“Credit”: corporate and asset-backed indices, bonds and CDS

“Systematic”: rules-based futures trading

“Discount Management”: buyback activity for discount management purposes
Manager's Market Review and Outlook The information in this section has been provided to BHM by BHCM
US
The year ended much as it began, with healthy gains in employment contrasting with anaemic growth. The economy appears to have expanded by approximately 1.75% in 2015, paced by consumption spending and held back by the drags from international trade and inventory destocking. The fundamentals in the household sector are solid. Real income is expanding at a moderate pace, wealth as a share of income is relatively high, balance sheets are in good shape on average, and credit is readily available for most borrowers. As a consequence, there is renewed vibrancy in the housing sector and brisk demand for consumer durables like motor vehicles. The inventory destocking appears to be a largely one-time adjustment that weighed on growth in the second half of the year, just as the sharp decline in capital expenditures in the energy sector subtracted from growth in the first half.  Meanwhile, the headwinds from international trade are likely to persist in 2016, both because such adjustments tend to take longer and because the US dollar continues to appreciate. We anticipate 2016 mostly reflecting a repeat of the trends seen in 2015 without the drags from inventories and energy-related investment. In terms of risks, consumption could surprise to the upside if households spend more of the wealth accumulated over the last few years; however, global growth could disappoint further and lead to worse net exports, or the energy sector could suffer another round of cutbacks if low prices persist.

The labour market was the highlight of the macro story in 2015. The US added 2.65 million jobs over the year and the unemployment rate fell from 5.7% to 5.0%, which is close to most estimates of full employment. If forecasts are correct and growth is above 2% in 2016, then the unemployment rate should continue to fall. The performance of the labour market is even more remarkable given lacklustre real GDP growth. The data suggest that potential growth is considerably slower than most estimates. If potential growth were 2%, then the unemployment rate should have increased during a year of sub-2% growth. In fact, since the unemployment rate dropped so much, the likelihood is potential growth is closer to 1% than 2%, a sobering fact with negative long-term consequences for economic performance and policymaking. To help appreciation of that difference, the economy would double in size every 35 years at 2% growth and only every 70 years at 1% growth. In other words, productivity growth looks stagnant, which means that there’s little room for real wage gains. In addition, lower potential growth means the economy will flirt with the zero lower bound on nominal interest rates whenever there’s a downturn. All of these implications—slow potential growth, weak productivity growth, and monetary policy that’s constrained by the zero lower bound—are negatives that will probably continue in 2016.

If the labour market was the highlight of the macro story in 2015, then inflation was the worst. For most of the year, total consumer price inflation bounced around a little above zero and core inflation was stuck at 1.3%. The reasons for low inflation are no mystery. Total inflation is being held down primarily by the huge decline in consumer energy prices and core inflation is weak because of the pass-through of lower prices for energy and imports. These are shocks to the price level so inflation should eventually pick up, but this is taking longer than expected because energy prices continue to fall and the US dollar keeps appreciating, thereby lowering import prices. The outlook for inflation in 2016 resembles the outlook for inflation at the beginning of 2015, calling for a slow pick up in headline and core. However, that’s contingent on energy prices and the USD finding some equilibrium.

In terms of policy, the Federal Reserve raised rates in December, ending months of speculation about the timing of lift-off. The debate immediately turned to the pace of monetary policy normalisation, with the policymakers promising “gradual increases” in rates while the market is sceptical that the economy can withstand any further removal of accommodation. The gulf between a dovish Fed and an even more dovish market will play out over the course of the year. Fiscal policy has merited almost no attention in the last few years, apart from the periodic scares about the debt ceiling and government shutdown. However, at the end of the year Congress agreed on a budget that should add a few tenths to real GDP over the next two years. Looking forward, the Presidential election looms in November. Although the market’s attention is focused elsewhere at the moment, there will be a keen interest in the election by the summer when a more liberal Democratic party faces off against a more conservative Republican party.  The country is deeply divided and there will be volatility no matter the outcome of the election.

EMU
2015 started with the ECB announcement in January of a new €1.1 trillion bond purchasing programme, known as “APP” (Asset Purchase Programme), a new monetary policy instrument that had been partly anticipated by financial markets at the end of 2014. The programme, consisting of both sovereign and sub-national debt purchases, came as a complement to the private assets bought since the end of 2014, with a total volume of €60bn per month. Although the ECB Quantitative Easing (“QE”) programme was implemented successfully and real GDP growth climbed to approximately 1.5% in 2015 from 0.9% in 2014, the economic recovery continued to be fragile, as the impulse from QE diminished during the year, resulting in inadequate stimulus to withstand the intensifying headwinds stemming especially from the slowdown in global demand. Indeed, activity growth slowed from an annualised rate of 2.2% q/q in Q1, to 1.6% q/q in Q2 and 1.2% q/q in Q3. Although the labour market recovered further over the year, with the unemployment rate declining by one percentage point to 10.5% at the end of 2015, the adjustment remains slow, very heterogeneous across countries and far from enough to fill the still large output gap, as shown by the still very subdued wage dynamics. At the same time, price developments continued to undershoot both the ECB and market expectations, with HICP inflation averaging a very low 0.0% in 2015, much lower than the ECB predicted at the beginning of the year. This disappointing outcome, which risks structurally de-anchoring inflation expectations, stemmed especially from lower commodity prices, although core inflation also remained extremely tame, lower than 1%. As a result, the ECB objective of returning to its target of “below but close to 2%” in the medium term remains in jeopardy and the risks of fully-fledged deflation have not gone. As such, the ECB policy decision to ease monetary conditions only slightly in December and disappoint greatly financial markets expectations which they had previously raised could prove very detrimental for the economic prospects of the Eurozone. Indeed, following the decision, financial conditions tightened, inflation and inflation expectations fell, and the economic data disappointed.

Politically, the summer months proved highly volatile with Greece’s anti-austerity Prime Minister Alexis Tsipras calling a referendum as the highly-indebted country came very close to exiting the Eurozone. While a third bailout programme of €85bn was agreed in a last minute deal, the implementation of reforms and debt-relief discussions are likely to remain difficult. Moreover, political tensions are rising. The consequences of the immigration crisis, which has hit even the otherwise rock solid leadership of Chancellor Merkel, has seen increasing support for nationalist and populist parties in various countries of the common area.

Looking forward, the prospects for the Eurozone in 2016 look more challenging than in 2015. Indeed, on the one hand, the above mentioned tightening of financial conditions induced by the December ECB policy decision, albeit moderate, came at a moment when renewed easing was needed so as to provide fresh impulse to the quantitative easing manoeuvre, amid the challenges posed by the risks of deflation, a slower and riskier global environment and a still challenging and far from complete process of de-leveraging. Risks that the December ECB macroeconomic projections of accelerating recovery and convergence to price stability will be greatly disappointed look particularly elevated. Should that be the case, pressure on the ECB to ease monetary conditions again, making use of all its available instruments, will increase.

UK
Entering the seventh year of its expansion, the UK economy has lately been marked by a dichotomy between developments on the real and nominal sides: while indicators in real, or volume, terms have proved resilient – although not completely immune to the global slowdown – indicators in nominal, or price, terms have remained sluggish. For instance, while real GDP likely expanded by about 2.2% in 2015, both headline and core inflation remained low, at 0.0% and 1.2% y/y, respectively. Similarly, while on-going strong job growth led to a further drop in the unemployment rate, the tightening of the labour market failed to translate into meaningful upward pressure on nominal wages. As inflation keeps undershooting the Bank of England’s 2% inflation target, the Bank remains in no hurry to hike rates in the near future, especially as the economic outlook in the short term has become more clouded. First, the past appreciation of Sterling still poses a headwind to the economy, weighing on exports. Second, fiscal policy should become slightly more contractionary this year, compared to the last couple of years. Thirdly, the uncertainty surrounding the EU referendum may result in companies putting investments on hold until the uncertainty over the UK’s future in the EU has been removed. Thus, even in a scenario where the UK remains a member of the EU, confidence may be adversely affected in the run-up to the referendum. In the alternative scenario, where the UK votes to leave the EU, the economy would likely suffer more, at least in the short term. Moreover, such a scenario would rekindle fears over a break-up of the UK, as the question of Scotland’s independence could come back on the table.

In our base case, the UK economy will continue its expansion and make up for any pre-referendum slowdown in the data once the referendum has been held, driven by robust gains in incomes in real terms – due to inflation rates even lower than nominal wages growth – over the past couple of years and an on-going need for housing and infrastructure investment. The gradual erosion of spare capacity and the further tightening in the labour market should eventually set the scene for the first rate hike, but only once wages growth have shown clearer signs of acceleration. However, the risks remain skewed towards a later rate hike, due to a weak global backdrop, the sensitivity of the currency, uncertainty about the new level of the non-accelerating inflation rate of unemployment (NAIRU) and an elastic supply of labour to the UK from the EU. Lastly, the Bank of England may well decide to implement macro-prudential measures to tackle any signs of overheating, which could weigh on economic activity and act as a substitute to monetary tightening.

Japan
While 2014 was marked by a large swing in activity due to the introduction of the consumption tax hike, 2015 saw steadier, modest gains for the most part.  The output gap stepped down 1 percentage point at the start of the year and was flat thereafter.  The unemployment rate maintained its downward trend seen over the previous five years and looks to end 2015 at its lowest level since 1997.  For the most part, survey measures like the Tankan and Shoko-Chukin survey of small and medium-sized businesses moved sideways over the year, and industrial production was flat on balance. 

Looking to 2016, Japanese growth is likely to be tepid, averaging fairly close to the slow rate of potential output growth.  Solid momentum in private domestic demand, supported by ongoing income gains, should be partially offset by a difficult external outlook due to the recent strength in the yen, as well as ongoing weakness in major Asian export markets.  Government spending could be a slight drag on the economy, and we see no reason to suppose that the upcoming corporate tax rate cut will materially boost aggregate demand in the near term.
The inflation performance was mixed over the year.  Abstracting from the effects of the consumption tax increase, the year-on-year change in core prices was relatively flat in 2015, remaining within a thin band straddling 0% throughout the year, as falling energy prices, which are included in Japan’s definition of core inflation, held down the aggregate.  On the other hand, the 12-month change in consumer goods excluding food and energy steadily moved up.  Stable 0.1% seasonally adjusted month-on-month gains were added to the 12-month change, while essentially flat readings in 2014 dropped out. 

After significantly boosting its bond buying in October 2014, monetary policy was essentially on hold throughout the year.  The Bank of Japan (“BoJ”) tweaked its policy at the December meeting by extending the maturity of the bonds it will buy from ten to twelve years, and introducing a new program to buy exchange-traded funds of stocks issued by companies actively investing in physical and human capital.  Markets initially rallied, thinking that it represented a true increase in policy accommodation, but then they pulled back once they realised their extremely limited nature.  The Bank went on to describe its actions as a technical adjustment.  All told, it served to raise questions as to whether the BoJ will revert back to incremental policy changes, without actually moving the needle on accommodation.  Governor Kuroda had said a month earlier that the BoJ needs to lead markets in pushing up inflation expectations; it cannot simply rely on wages to pick up on their own.  With Governor Kuroda’s aide recently saying that the conditions are in place, more accommodation looks to be under serious consideration.

Indeed, the need for further accommodation has increased of late as the re-inflationary backdrop has deteriorated.   In the second half of December, the yen appreciated over 2% against the dollar and then opened the year strengthening another 2%.  Oil took another step down, and while the BoJ is capable of separating the direct effects of oil on its definition of core inflation from changes in the underlying trend, there are still some spillover effects to non-energy prices.  Consumer inflation expectations appear to have stumbled in the last few months with a weighted average of household inflation expectations falling 0.6% from its first-quarter average.  Spring wage negotiations appear to be disappointing.  All told, while the 12-month change in core prices should move up due to base effects as the previous sharp declines in energy prices fall out of the calculation, in this environment further inflation gains excluding food and energy are not in the offing.

China
2015 was a most challenging year for China, gripped by an extremely challenging combination of high and still rising leverage, and slowing underlying growth, both in real and nominal terms, as large overcapacity in a number of sectors induced deflationary pressures. Attempts by policy makers to ease monetary conditions in the form of cuts to the reserve requirement ratio (“RRR”) and official interest rates, showed diminishing returns in terms of their ability to generate credit and boost economic activity. This is perhaps unsurprising as the transmission mechanism tends to lose its effectiveness in a high leverage environment. As a result, in 2015 GDP growth slowed from 7.7% to 6.9%, the lowest in 30 years, although broadly in line with the government “about 7%” target. Speculation on the accuracy of the China growth data has risen, as many analysts believe that the actual growth rate is lower than the published figure. Moreover, China’s stock and foreign exchange markets witnessed great turbulence. Indeed, on the one hand the Shanghai composite index after nearly doubling from November 2014 to mid-June 2015, subsequently collapsed returning to its January 2015 level. On the other hand, the Yuan depreciated by approximately 3% from mid-August 2015 to year-end, despite massive intervention by the People’s Bank of China (“PBoC”) aimed at stabilising the exchange rate until it joined the IMF SDR basket on 30 November. Importantly, capital outflow pressures persisted thereafter. Throughout the whole of 2015 foreign exchange reserves contracted by more than US$500bn, to US$3.3tn.
Looking forward, 2016 looks as if it could be another turbulent year for China. In particular, capital outflow pressures are likely to persist despite tightened capital controls and a large current account surplus, along with the rising demand from onshore corporates and households aimed at diversifying their assets from RMB into USD. The on-going anti-corruption campaign could also exacerbate capital flight. As such, the PBoC will likely encounter increasing difficulties in smoothing out the pace of the depreciation, as the costs in terms of reserves’ depletion are likely to rise. The official GDP growth target for 2016 is likely to be lowered to about 6.5%, a result which may be a challenge to achieve given the increasing ineffectiveness of the monetary transmission channel and the limited room to ease monetary policy conditions amid rising outflows. Fiscal policy is likely to be expanded, but not to an extent which can stabilise the economy, as only small-scale fiscal easing measures are poised to be introduced after the March National People’s Congress. Last, but not least, elevated volatility in financial markets is likely to persist, at least until such a time as the exchange rate is let freer to adjust to market forces, thus damaging growth prospects.
Enquiries Northern Trust International Fund Administration Services (Guernsey) Limited
Harry Rouillard +44 (0) 1481 74 5315

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Source: PR Newswire (January 29, 2016 - 8:39 AM EST)

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