Seth Bernstein

New dynamics are coming to the fore in the way that global and Australian fund managers think about their businesses and deliver value for clients, the global head of investment firm AllianceBernstein (AB) said in Sydney yesterday.

Seth Bernstein, AB’s President and Chief Executive Officer, said that the industry was entering a new phase of change which added to improvements introduced since the 2008 global financial crisis.

“After the crisis, AB and many other firms understood that serving our clients well in the new market environment required a radical shift away from the old ways of thinking about investment.

“We realized, too, that clients wanted to know more about our corporate culture and values, and what we were doing to leverage the benefits of technology in our business.

“What’s significant now is how important these conversations about culture and technology have become―even more important than they were before.”

After the crisis, AB and other active managers introduced investment strategies which were benchmark-agnostic, and asset-allocation concepts which went beyond the old equity/bonds paradigm and looked instead for risk and return opportunities across the asset spectrum.

AB, for example, responded to client demand by broadening its investment platform to include multi-asset and alternative investment strategies, and a more closely integrated global research platform in which analysts from all asset categories talk to each other and share insights daily.

“These changes have worked well, but competition continues to be relentless across the industry and market conditions remain challenging, as evidenced by recent volatility,” said Bernstein.

“While we continue to innovate in our differentiated investment offerings we are also looking at corporate culture and technology as areas where we can compete and add value for clients.”

AB’s culture has always been collegiate and client-centric, said Bernstein, and a key attribute in attracting and keeping good employees and helping to ensure client satisfaction. Increasingly, AB is finding that its diversity and inclusion policies are making important contributions in these respects.

“If you want to attract and keep the best people, you need a culture that promotes diversity and inclusion across all demographics,” said Bernstein.

“We’re proud, for example, that, for three years in a row, from 2016 to 2018, AB achieved a perfect score of 100 on the Corporate Equality Index, a US national benchmarking tool on corporate policies and practices for LGBTQ employees.

“Our efforts in technology have also been focused on improving our value proposition for clients. For example, Abbie, our virtual bond-trading assistant, provides a range of automated services, all delivered through natural language processing.

“Her tasks include responding to requests for holding information and on-the-run treasury bond characteristics, telling you the credit bucket breakpoints for any benchmark and―particularly important in today’s market conditions―identifying liquid bonds.

“The efficiencies she has introduced have been of direct benefit to clients and have led to AB becoming an acknowledged leader in this field of technology.”

Bernstein noted that these developments, while not directly investment-related, were in fact aspects of AB’s core focus on investment risks and opportunities.

“The risk environment we face today is very different from the one that preceded the 2008 crisis. It includes many new factors, such as Brexit, populism, the US’s diminishing dependence on global oil supplies, China joining global indices and experiencing slower growth, and growth in global debt.

“There are a lot of imbalances out there and they’re likely to cause a few tremors.

“I don’t know how big those tremors might be, but the fact that so many new risks exist is, to me, a powerful argument for maintaining a suitable exposure to active investment strategies.

“They might be a good, alternative way to negotiate uncertainty compared to, for example, passive exchange-traded funds which, while cheap, aren’t necessarily risk-free.”

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“While passive investing is cheaper on the surface, we think investors are taking on more risks than they know,” said Mark Phelps, AB’s Chief Investment Officer—Concentrated Global Growth.

“Concentrated investing has actually provided a better risk/return profile than traditional or passive strategies. Surprisingly for many people, not only can it provide better excess and risk-adjust returns, it can reduce downside risk, too.”

While it’s true to a point that adding more stocks to an equity portfolio helps to reduce volatility, the benefit declines when the number of stocks passes 20 or 30, as it becomes harder for investment managers to reduce tracking error (a measure of how closely a portfolio follows its benchmark).

“This leaves a strong case to be made for quality of stocks, not quantity, in portfolio construction,” said the London-based Phelps. “By using research to focus on fewer but higher-quality stocks, concentrated investing has the potential to produce substantial alpha through security selection.”

Phelps noted that, historically, concentrated managers have been very successful.

“The median concentrated manager has delivered 3.32% alpha over the last five years and 3.76% over 10 years. Traditional managers have also produced alpha, though lower than those of concentrated managers (1.76% over five years and 1.87% over 10 years).

“Passive managers have posted slightly positive (3 basis points) excess returns over both time periods. Clearly, there is sometimes power in fewer stock holdings.”

One aspect of concentrated investing’s outperformance has been its upside/downside capture, or the percentage of up and down markets “captured” by an investment.

“Concentrated managers have delivered solid upside capture during the past 15 years, although less than that of traditional strategies,” said Phelps. “But their downside capture of 88.9% is lower than that of traditional managers (96.1%) and passive managers (99.9%).”
While attractive in its own right, concentrated investing can also be effective as a complement to passive investing.

“Over the 15 years ending December 31, 2015, a blend of 50% concentrated equities and 50% passive equities produced a higher annualized net-of-fee return than a passive-only strategy with slightly lower risk. The blended strategy was also better in terms of downside protection.

“These figures show the potential benefits to investors in today’s markets of sticking with a concentrated approach over the long term, and combining a concentrated approach with a passive strategy.”

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Inflation targeting

In recent years, central banks in several developed economies have adopted formal inflation targets. Proponents have claimed this would create greater transparency in the decision-making process and help central banks better communicate the reasons and rationales for any policy changes. The core reason behind this was that a low and stable inflation environment would anchor inflation expectations and also lead to greater macroeconomic stability.

Success for this type of monetary policy framework depends as much on selecting the appropriate basket as it does on the specific price target. US policymakers have selected the consumer price index (CPI) as the appropriate basket of items. At first glance, this traditional price index would seem to be the most appropriate measure of price change, since it captures the most dominant part of final demand.

However, the current structure of the CPI does not directly include the price of housing. Instead, the government statisticians create a proxy for house-price inflation based on trends in rents. This creates both a reality and a measurement problem because the rental market and the owner housing market are distinct markets.

Indeed, the current structure of the inflation-targeting framework sets a speed limit for a large chunk of the consumer basket—and no speed limit for housing. And policymakers only react to price changes in the housing market if the speed in housing prices creates a higher speed rate in the targeted basket of consumer items, or if house prices crash and burn and there is a potential spillover effect (negative) on the targeted basket.

Why this inflation-targeting framework is flawed

Housing, more than any other product or service in the economy, is highly influenced by the cost of borrowing, liquidity conditions and (at times) speculation. Directly and indirectly, all three of these conditions are influenced by the stance of monetary policy.

Also, the acquisition of housing involves the accumulation of debt. Consequently, by not formally monitoring prices and credit use, policymakers run the risk of creating macro imbalances in the economy that could become systemic.

 Economic performance during the inflation-targeting regime

In the US, an informal and formal inflation-targeting regime has been in place for more than two decades. The resulting macroeconomic record is poor—if not worse than before.

First, the 2000s decade had two economic recessions; its performance matched the uneven economic performances of the 1950s, 1970s and 1980s. Moreover, the 2007–2009 economic downturn was the longest in duration (18 months) and deepest in terms of depressed gross domestic product (GDP) output (–4%), lost jobs (8.5 million) and shrinking household wealth ($12.7 trillion) in the postwar period.

Second, the economy spent 26 months in recession during the 2000s—a period marked by low and stable inflation. The only other decade that recorded as many months in recession was the 1970s—a decade marked by high and accelerating inflation.

Why isn’t the trade-off between low and well-anchored inflation and economic performance any better than it was during high and rising inflation? Is the inflation-targeting regime flawed or have policymakers selected the wrong basket?

Proposed changes to the inflation-targeting framework

Olivier Blanchard, the chief economist for the International Monetary Fund, argues that inflation targeting has not worked because the specific inflation target has been set too low. He and other policymakers and academics continue to debate and question what the optimal inflation target is. Some of them suggest that inflation targets be set as a high as 4%.

While the setting of a price target is important, it’s not as important as the specification of the price measure, in our opinion. That’s because central banks can influence the cost of borrowing and aggregate liquidity conditions, but they cannot direct the liquidity flows. Only the private sector will push the flows in the directions that fit its needs.

Formal price targeting can only work well if policymakers focus on actual prices and include prices that are most sensitive to monetary policy changes. Any attempt to add more monetary stimulus to the system, with the simple goal of trying to achieve a narrow price target, is likely to result in even greater price imbalances and potentially more economic instability.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. Note to Australian and New Zealand Readers: This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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About the Liquidity Flows Indicator The Bureau of Economic Analysis (BEA) designed the liquidity flows indicator decades ago. The original series was based on the concept that changes in liquid balances lead to directional movements in nominal spending, with a lead time of six to nine months.

The original series consisted of the growth in broad money (adjusted for inflation), the growth in business and consumer credit, and the change in liquid assets.

Simply stated, the liquidity flows indicator captures all the ways spending might be financed: cash, credit or liquid assets. Financial markets have evolved since the series was initially constructed. As a result, some modifications were necessary. Over the lifespan of the series, one of the biggest developments was the birth of the mutual fund industry and the inclusion of dollar flows into bond and stock funds.

If the liquidity indicator had failed to capture these flows, it would have been missing a large and growing part of liquid balances, since mutual fund accounts are highly liquid assets and serve as very close substitutes for traditional bank accounts.

Working with statisticians at the BEA, we redesigned the series and revised the liquidity flows indicator, which has been one of our proprietary indicators for the past 25 years.

Recent Forecasting Record

To be fair, growth of the liquidity flows indicator has overstated real gross domestic product (GDP) growth for the past several years (Display 1).

Part of this overcalculation can be explained by the indicator’s direct link to trends in the private sector and lack of any link to the public sector; growth in credit and liquid balances captures the borrowing trends of nonfinancial corporate businesses and households and their liquid balances.

Over the past six years, average annual growth in the liquidity flows indicator was 3.3%, compared with 2.9% in private sector GDP. Overall real GDP growth of 2.1% came in well below trends in the private sector, because the public sector has contracted 1.3% per year since 2010.

1986 and 1998 Offer Clues for 2016

The liquidity flows indicator is sensitive to changes in interest rates, lending The US economy has faced persistent fears of setbacks, but the recovery continues to move forward. Our proprietary liquidity indicator suggests that the economic cycle remains on solid ground and that GDP growth in 2016 will be faster than in 2015. conditions and the inflation rate. Over the past several months, the sharp outflow from equity mutual funds, which are included as liquid assets, has held back the growth rate of the overall indicator, but haven’t altered the underlying trend.

Sharp declines in energy prices that lead to a sizable drop in headline inflation have given a big lift to liquidity flow growth over time. Two periods—1986 and 1998— highlight this relationship. In those years, a 40% to 50% decline in energy prices triggered a 1- to 1.5%-percentage point drop in headline consumer price inflation, lifting real liquid balances. A similar phenomenon occurred in 2015; oil prices fell by close to 50% and headline inflation dropped 1.5 percentage points from 2014.

The link between stronger growth in liquidity flows and faster spending growth isn’t immediate. In fact, stronger flows suggested faster economic growth in 1986, but there was a noticeable drop in overall GDP growth of about threequarters of a percentage point. But the rebound in liquidity flows ultimately did translate into higher spending, with real GDP growth rebounding strongly in 1987. The playbook for 1998 was different: growth remained strong in that year and the following year.

If yesterday’s playbook is still accurate, real GDP growth should rebound by at least one percentage point in 2016, up from 2.4% growth in 2015.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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“The notion that bonds can still have an important role to play in portfolios may surprise many investors—particularly those focused on home-country markets,” said John Taylor, AB’s London-based Portfolio Manager—Fixed Income, while visiting Australia this week to see clients.

“It’s no secret, however, that looking beyond the front door to global bond markets can help investors improve their risk-adjusted returns.”

Taylor noted that many investors have become wary of holding bonds since the global financial crisis, in the aftermath of which interest rates in many developed countries have fallen dramatically and central-bank buying of government bonds has forced yields to record lows.

He added, however, that it was important to understand that “not all bonds are created equal”.

“Although the bonds referred to in media headlines are usually government securities, bond markets are actually quite diverse. In addition to government bonds, they include corporate bonds or credit and other, more specialized, securities, such as mortgage-backed bonds.”

This diversity becomes even greater when global bond markets are taken into account. Global government bonds include those issued by sovereign borrowers in most if not all developed economies and many emerging economies, too.

Typically, this results in a greater opportunity to reduce risk and improve returns, arising from the fact that different countries tend to be at different points in their economic and monetary-policy cycles at any given time.

“This is particularly the case now, when global divergence in policy cycles lies behind much of the volatility being experienced by financial markets,” said Taylor.

“For example, although the Fed is raising rates in the US, Japan is still in the middle of a quantitative-easing programme—indeed, the Bank of Japan recently became even more accommodative by introducing a negative interest-rate policy—and we expect Europe to expand its quantitative-easing programme in March.

“In other words, even if interest rates in one country keep rising, those in other developed markets may fall—and create actionable opportunities for bond investors. The same may be true for emerging-market bonds, yields on which have risen recently, to the point where some reversion to more normal levels might be expected.”

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The Economy in 2015

The economy slowed sharply in the fourth quarter, with real gross domestic product (GDP) growth rising at a mere 0.7% annualized rate. Once again, the strength of the economy’s performance was driven by household spending and investment. Real consumer spending on durable goods rose at a 4.3% annualized rate, while spending on housing climbed by an 8.3% annualized rate.

Despite these bright spots, the economy’s performance was negatively impacted by a series of items: Energy capital spending in structures declined by a 39% annualized rate; foreign trade subtracted 0.8 percentage from the quarter’s growth performance as real merchandise exports declined while real merchandise imports rose; companies scaled back on inventory investment, subtracting 0.5 percentage from the GDP growth rate; and unusually warm weather dramatically reduced household spending on utilities.

For 2015 overall, real GDP growth rose 2.4%, matching the growth rate of 2014. Depending on one’s perspective, the US economy was able to overcome the 50% collapse in energy capital spending (which subtracted 0.5% from the overall growth rate) and still post a modest advance in overall growth. Alternately, the fact that real GDP growth in 2015 only matched the pace of growth in 2014 suggests that the economy did not see any benefits from the sharp drop in energy prices.

History shows that the negative effects of sharp and large declines in energy prices are front-loaded, and that the positive benefits tend to surface 6–12 months after the initial drop in prices. The fact that energy prices have taken another nosedive in January indicates that there is still downside risk to energy capital spending in the first half of 2016. Also, the knock-on effect to equity prices has the potential to impact consumer spending—but so far there is little evidence of that in the sentiment reports and other hard data.

As we noted in our last commentary, incremental declines in energy capital spending and declines in equity markets (with negative wealth effects on consumer spending) raise the downside risks to our 2016 GDP growth estimate. Based on recent trends, we think it is prudent to lower this year’s growth rate to 2.7%— down from the initial estimate of 3.2%.

Fed policy

At the January 26–27 Federal Open Market Committee meeting, policymakers noted that the pace of growth had slowed in the fourth quarter, even though labor market gains stayed relatively strong. Yet the confusion caused by ongoing volatility in the energy markets and global financial markets left policymakers generally unsure about the growth and inflation outlooks.

As a result, they stated that they would be “closely monitoring global economic and financial developments and assessing their implications for the labor market and for the balance of risks to the outlook.” Clearly, policymakers are saying that it might take more time for them to gain clarity on the outlook—especially on the inflation front. Thus, delaying a rate hike until midyear is going to be the most likely result of their discussions. Consequently, we don’t expect the next official rate hike until the second quarter, probably June. And we are reducing our estimate of the number of rate hikes to three from four.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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Oil-price plunge: A historical perspective

In the summer of 2014, domestic spot oil prices hit a peak of $108 a barrel. They’ve been on a steady but irregular decline ever since. Currently, the spot oil price for West Texas Intermediate oil is roughly $30 a barrel. That’s the lowest price since 2003, and it represents a decline of nearly 75% from its summer 2014 peak.

To understand potential repercussions, we compared the current oil-price plunge to that of the 1986 drop (Display 1), because both price declines were driven primarily by an additional (unexpected or unappreciated) increase in available supply.

In September 1985, OPEC increased its oil production and lowered its price. At year-end 1985, OPEC members shifted from a policy of targeting prices to one of focusing on market share. In part, that policy change occurred because OPEC was worried about the increased oil supply coming from the North Sea. So, to thwart competition and keep its market share, OPEC lowered its price.

The additional supply catalyst in 2014 stemmed from an increase in US oil production—a direct by-product of shale technology. In fact, US oil production in 2014 had increased by 4 million barrels per day from 2010, thereby boosting domestic production to its highest level since the 1970s. As global prices fell, OPEC again sought to preserve market share and responded by maintaining current production. This surprised non-OPEC oil producers and investors, resulting in a plunge in oil prices that even the most pessimistic forecasts of 2014 did not anticipate from the outset.

Economic adjustments

Sharp and large downward changes in oil prices produce a string of economic adjustments, both negative and positive.

The most obvious negative adjustment is in the capital spending of energy companies. The sharp curtailment in oil-rig construction has resulted in a 50% reduction in nonresidential structures in investment in the mining and energy segment—a decline that’s roughly comparable to the peak-to-trough decline in 1986. However, the oil-price decline of 2014–2016 is larger than that of 1986, and there is no clear indication of when prices will bottom, let alone rise again. Consequently, we expect further declines in this investment segment.

On the flip side, the manufacturing-sector investment in new structures increased roughly 50% over the course of 2015, and now stands slightly above that of investment in energy-related structures (Display 2, next page). The last time investment in manufacturing structures exceeded energy-related investments was in the early 1970s.

Shifting consumer preferences

Disruptive changes have also occurred in consumer preferences. For example, in 2015, new vehicle purchases totaled 17.33 million. Albeit, that sales total fell just short of the record 17.35 million set in 2000. But purchases of trucks (light and heavy) did set a record. According to Ward’s Automotive, 10.3 million trucks were purchased last year, exceeding the prior sales total by 1 million and representing the highest tally ever (Display 3). Lower gasoline prices were a clear factor in the strong sales performance.

The shift in buying patterns toward lightduty trucks has pushed motor vehicle manufacturers to alter and rush their investment plans. Domestic firms as well as foreign transplants are adding billions of dollars to their investment plans in the US. The goal is to increase domestic production capacity for trucks, based on what they see as a permanent shift in buyer preference. This clearly reflects the view that oil prices will be low for a long period. And that influx of investment dollars will add to the strong uptrend already apparent in new structure investment by manufacturers.

Shifts in US consumer behavior are also evident in driving patterns. Total miles driven in 2015 reached a record level, and the increase in miles driven represents the largest annual gain since 1992. A more mobile consumer results in other spending-pattern shifts. For example, the greater use of a vehicle results in more wear and tear, which increases spending on maintenance and shortens the life of the vehicle. Also, spending on services such as eating and drinking away from home and domestic travel increased as well.

The sharp drop in oil prices plays a large part in overall pricing patterns and other disruptive economic changes, too. Businesses, with the greatest benefit flowing to transportation companies, consume as much energy/oil as consumers, so a sharp and permanent drop in fuel costs can motivate firms to upgrade their fleets, as well as pass along the windfall to shareholders, workers or customers. It’s hard to say at this juncture with any certainty how energy-consuming firms will spend the windfall, but it is an accumulating benefit and hugely positive to the broad economy.

How low? How long?

How deep oil prices plunge and how long they remain low have important implications for monetary policy. Policymakers have been arguing that the oil-price decline is a temporary phenomenon: as prices flatten or stabilize, headline inflation will start to move up, more accurately reflecting current trends in core prices, which increased 2.1% in 2015 (according to the Consumer Price Index).

Yet the sharp oil-price plunge in just the first few weeks of 2016 further delays any rebound in headline inflation. And since several policymakers raised concern over the inflation outlook at the December Federal Open Market Committee meeting, it’s quite possible that policymakers could signal a delay in the rate normalization policy at next week’s meeting.

All in all, we tend to view an energy-price decline as a net positive for the economy over a 12- to 18-month period. Yet the initial negative impacts tend to outweigh the positive—so growth and inflation could be about 0.5 percentage point below our forecasts for 2016 if oil prices remain at current levels through the end of the first quarter.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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However, Mark Phelps, AB’s Chief Investment Officer—Concentrated Global Growth, says that pricing power can help investors identify companies that are capable of delivering sustainable growth in this environment.

“In a low growth world, pricing power can unlock higher profits. But with inflation stuck at very low levels—0.5% in the US and about 1.0% in the euro area—it’s not easy for companies to raise prices, says Phelps.

Pricing power is about more than the simple ability to raise prices, however. According to Phelps, in order to find companies with pricing power, investors need to understand the three keys to pricing power: innovation, competition and cost dynamics.

“Innovation is a great enabler of higher prices,” says Phelps. “Technology companies that create products or services that never existed before can command higher prices. The same can be said for drug makers who develop new treatments.”

Pricing power is often a function of the competitive environment. “Take the supermarket industry in the UK, where discount supermarkets such as Aldi and Lidl have cut prices so low that they are creating big problems for giant rivals like Tesco and Sainsbury.

“The premium brand supermarkets today can’t use their usual tactic of regularly raising prices slightly in a world without meaningful inflation. This same logic can be applied to other industries where low-cost providers have taken market share, from airlines to finance.”

In a low-inflation world, cost dynamics are crucial. “Consider a company like Ecolab, which makes cleaning chemicals derived from oil-based products. With oil prices at extreme lows, Ecolab’s input prices have dropped dramatically. So even without raising prices, profitability can increase.”

Pricing power is always an important component in the fundamental analysis of a company’s business model and earnings prospects.

“Today, with big challenges facing top-line growth across an array of industries, we believe that it is essential to understand pricing power to develop high conviction in specific stocks,” says Phelps.

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Progress in China’s reforms is often a case of “two steps forward and one step back.” If 2015 was a year of the two steps forward, is 2016 going to be a year of the retreat? Or will Beijing manage to avert an economic crisis and move closer to its long-term reform goals?

Policymakers are faced with a major conundrum, as the renminbi’s (RMB) volatility has increased, capital outflows have intensified and depletion of foreign reserves has accelerated (down some US$663 billion from their peak in June 2014) as a result of market intervention to stem the RMB’s precipitous decline (Displays 1 and 2).

Policy Trilemma

The problems seem vast and complex. But, in our view, they boil down to whether the administration wants to resolve, once and for all, the “impossible trinity” problem.

In international economics, it is well known that a country cannot simultaneously control interest rates and its currency while allowing free capital flows. Policymakers can only control two of those three elements and must forgo one. If capital flows are not to be restricted, the options for the authorities are either to pursue a stable exchange rate and forgo an independent interest-rate policy (as local rates will need to move in tandem with world interest rates), or to set their own interest rates but give up direct control of its currency (because the exchange rate will be determined by fund flows, which will be driven by interest-rate differentials). Alternatively, they can control both interest rates and the exchange rate, but in that case they will need to close the country’s capital account. The bottom line is, something has to give.

In China, the currency and the capital account have been mostly quite rigid, giving domestic monetary policy flexibility. But the ongoing liberalization in the currency and the capital account leaves only inconvenient options for Beijing in the face of persistent capital outflows—allow the RMB to depreciate freely; raise interest rates high enough to defend the currency (at the cost of sabotaging growth); or just shut down the capital account again.

If China wants to pursue free capital flows but not let go of its control over interest rates and the exchange rate, the only way would be to keep spending its foreign reserves to fight the tide on the foreign exchange market. But this obviously runs the risk of a quick depletion of the reserves, which in turn would add pressure on the currency again. China has never been in favor of a “big bang” reform. And with almost US$4 trillion of foreign reserves, we previously thought that the country would be able to implement liberalization at a measured pace, step by step. This, however, has not proved to be the case. The volatility in current global markets shows that the “China impact” was underappreciated, and the vast amounts of foreign reserve dollars wasted in fighting capital outflows are now being questioned.

Essentially, China currently has a choice of either letting the currency truly float, fulfilling market expectations, or resorting to capital controls (euphemistically termed “macroprudential measures”) to stop the bleeding for a while. Either way, there are consequences to bear.

Command and Control

If Beijing chooses the path of currency depreciation, it will be hard to tell where the bottom might be for the RMB. The currency may be liable to overshoot on the downside if fears in the market intensify.

Another aspect to consider is whether a cheaper currency can really boost export competitiveness when global demand is so sluggish. Sizable currency depreciations in South Korea, Taiwan and Singapore over the past year have done little to boost their export performances. Ironically, these countries all suffered bigger export contractions than China despite their weaker currencies.

Also, a big currency depreciation will heighten many Chinese corporations’ external repayment risk, since they have taken on considerable amounts of offshore liabilities over the past several years, when the renminbi was more stable and predictable.

So how about the macroprudential option? It is debatable whether that will actually work well either, but it is becoming more popular among policymakers across the globe.

But there are clear risks, such as the damage to the credibility of China’s push toward a higher level of free-market economy. But if the macroprudential measures do work, China can let things calm down for now and restart the reform push when market conditions improve.

The outlook for the RMB is also very much a call on the US dollar’s (USD) broader strength. If the greenback peaks out against major currencies in 2016, a lot of the pressure on the RMB would fade away. In this case, too, China can restart reforms later. Policymakers could be criticized for merely pushing the problem out to a future date, but, in the big picture it may be a risk worth taking from Beijing’s point of view.

Stable Currency Basket

Recent policy communications from the People’s Bank of China (PBC) have repeatedly emphasized the referencing of its currency to a basket of currencies. Indeed, despite the volatility of the RMB’s exchange rate against the USD, its levels against the currency basket have been quite stable over the past several weeks. We think this stability against the currency basket will remain the policy objective in the near term (Display 3).

All told, what’s our view? In short, we’re not in the camp forecasting a big devaluation. Nor do we expect the PBC to start a depreciation of the RMB against a broad currency basket—if it did, the RMB would fail to gain much credibility as a reserves currency.

In our view, there is already evidence that the PBC is leaning toward scaling back its capital account liberalization in recent weeks. For example, it announced a ban on foreign banks from conducting cross-border foreign exchange transactions and arbitrage activities for three months.

Moreover, controls on the amount of money that local residents can take out of the country have been further tightened to RMB50,000, and the PBC is said to be considering new tools to narrow the gap between the CNH (offshore) and CNY (onshore) markets by more blatant and direct intervention measures in the market.

CNY/USD Forecast In terms of our forecast for the RMB, our base-case projection is that the PBC keeps the RMB stable against the currency basket, while the USD’s uptrend peters out in 2016. In this scenario, we think CNY/USD will be at around 6.60 on a six-month horizon (against 6.58 currently). Its relative value against CNH/USD will remain volatile, but we expect the PBC to step up its effort to reduce the gap between the two markets, limiting the deviations.

Ideally, an export recovery will act as a powerful circuit breaker for the renminbi’s downward spiral. But, unfortunately, we have reservations about that scenario. China’s economic growth may show more stability if housing investment makes a comeback in 2016. This would help improve expectations on the RMB in general, but it still may not be enough to change the sentiment on the country’s foreign exchange policy. And, in the end, it’s important to remember that the direction of the USD seems to be the most crucial factor.

By Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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Although some hard data have been weak, December survey data suggest that the euro area ended 2015 on a firm footing. Shaking off weakness in France (partly related to the November terrorist attacks), the composite Purchasing Managers’ Index (PMI) matched its high for the year, while the broadly based economic-sentiment indicator (ESI) reached its highest level since April 2011. Moreover, the services component of the ESI was at its highest since October 2007, highlighting the domestic nature of the recovery.

Sustained recovery

Helped by low oil prices and an increasingly supportive monetary/fiscal policy mix, we expect the recovery to continue in coming quarters. Our latest forecast (1.7%) is for growth to be a touch higher this year than it was in 2015 (1.5%). There are arguments for stronger growth, especially with fiscal policy turning overtly expansionary across the region (Display 1). But the recovery still faces important headwinds, not least in the form of weak emerging-market growth. Until the external backdrop improves, it’s difficult to see a material acceleration in the pace of euro-area growth.

Subdued price

Pressures Inflation ended 2015 on a soft note, with the headline rate unchanged at 0.2%. There are two main reasons for this. First, renewed weakness in the oil price means energy prices continue to exert significant downward pressure on inflation (knocking 0.6 percentage points off the headline rate in December). Second, while the economy is recovering, growth is not yet strong enough to generate sustained upward pressure on core inflation.

Unless the oil price continues to fall, base effects should push headline inflation higher over the coming year (Display 2). But with the recovery eating only slowly into abundant spare capacity and global price pressures weak, lifting core inflation won’t be easy. All the more so, with the impact of a weaker euro on core goods price inflation starting to fade (Display 3, next page), and with service price inflation—a key gauge of domestic inflation pressure—anchored close to record lows.

More monetary easing

For the European Central Bank (ECB), weak headline and core inflation are equally problematic. The former has been below 0.5% for 18 months now. And the longer it stays there, the more worried the ECB is likely to become about a possible “unanchoring” of inflation expectations.

But even if the headline rate starts to rise, confidence that it will stay there—a key condition for ending the ECB’s asset purchase program—will only be possible if it’s accompanied by a decisive increase in core inflation. And barring an unexpectedly strong pickup in growth or further sharp drop in the euro, that doesn’t look likely. That’s why we expect more monetary easing in 2016, helping to anchor bund yields and providing further support for peripheral bond markets.

Challenges and risks

Our central case is therefore that the recovery continues in 2016, but that growth isn’t strong enough to generate a sustained increase in core inflation. In which case, the ECB will probably ease policy further.

As usual, there are a number of risks to this view. The most important of these would be a hard landing in China. The resultant economic and financial shockwaves would weigh heavily on euro-area growth, triggering a more forceful policy response from the ECB.

Domestically, the main risks are political. While no major elections are scheduled this year, political fragmentation is now a fact of life in most euro-area countries. This has led to an unstable, left-wing coalition in Portugal and is complicating the task of putting together a viable government in Spain. At the same time, Greek risks lurk in the background and the euro area would not be unaffected should the UK vote to leave the European Union. Add to this another influx of migrants/refugees from the Middle East, and it’s clear that, even if the euro area is on a firmer footing, challenging times still lie ahead.

By Darren Williams, Senior European Economist, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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