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Global market risks outlined

London-based economist Andrew Hunt casts his eyes over global markets can concludes that markets will try to repeat last year's performance but there are some major risks to this happening. One of these is a recession in China. In this article he outlines the risks investors need to be aware of this year.

Friday, January 10th 2014, 1:20PM

by Andrew Hunt

With the continuing and pronounced weakness in world trade prices and the still generally sluggish economic environment that has resulted in the US Federal Reserve Board (FRB) only tapering its current asset purchase programme modestly, then we can expect that the FRB will likely provide a further nearly $1 trillion of “cash flow” to the financial markets over the next year.

Presumably, as the FRB buys in yet more debt securities, it will create yet more of a “hole” in the supply of good quality bonds available to investors and implicitly force – or at least encourage – the vendors of these bonds to continue to re-invest their funds into either corporate bonds (thereby implicitly funding yet more corporate issuance and hence even more equity buybacks by companies), directly into equity funds, or into overseas assets. 

If the FRB tapers more aggressively in 2014, the risk markets in general and, we suspect, the corporate bond markets in particular would lose much of their recent support and the US might even face a severe “monetary cliff” without the FRB’s actions (since the FRB remains the only real source of liquidity growth within the economy at present) but it is not our belief that the FRB will do much more in the way of tapering than the USD10b a month announced in December. Given that we suspect that the forthcoming “Volcker Rule” will likely continue to prevent the US commercial banks from creating much liquidity to the system, this will presumably oblige the FRB to keep buying bonds.

Hence, the FRB’s actions will likely continue to provide some form of flow of funds foundation for asset prices.

Moreover, we can also expect that the Bank of Japan will add more than USD500b of liquidity to Japan’s domestic liquidity through its own asset purchases, although we suspect that these will be partially offset by continued relatively heavy sales of JGB by Japan’s commercial banks. Elsewhere, we can perhaps expect some net injection of funds from the ECB, although the Eurozone commercial banks also seem to be moving in the opposite direction. German savers are, though, redeeming around USD150b of savings bonds per annum at present and we can probably expect another USD250b or more of capital outflow from China’s private sector savers. Both of the latter should help to provide some support to the equity and other risk markets.

In fact, taken together, we could easily suggest that these various flows could easily create $2 trillion of capital flows into the financial markets and this is the basis for the consensus view that markets will perform well again next year.  Admittedly, we suspect that this amount probably represents a slight drop in the overall rate of liquidity creation on this year’s rate and the “capitalisation” of the markets is now higher (implying that it will take more money to move them...) but, nevertheless, there would seem to be some “funds flow support” for the risk markets at present.

We can also argue that there is still some limited valuation support for asset prices. Although equity market valuations are not overly cheap, we would hesitate to suggest that they were too expensive either, particularly by the standards of the 1990s period of excesses.

Moreover, we would also note that we are beginning to become at least a little more positive on the immediate outlook for US corporate earnings. Continued low interest rates will continue to help earnings but we suspect that we could be on the cusp of another fiscal easing by the Obama Administration, as it turns its attention to the Presidential election cycle and, in theory at least, a fiscal expansion should be constructive for the outlook for US profitability.  

Finally, we should also note that for the first few months of the year at least, headline inflation rates in the West are likely to look either benign or perhaps a little low. This too can be expect to provide some encouragement to the financial markets and so we find ourselves strangely in agreement with the consensus that 2014 could at least start well for the financial markets. In fact, we would suggest that it would take something “pretty big” to derail markets in 2014 given this funds flow background.

Unfortunately and without wishing to be too overtly “party-poopers”, there are, though, a number of risk factors that we believe could very easily turn out to be more than capable of upsetting the consensus rather happy view of the world.

Firstly, there is the risk that the FRB does further taper its bond purchases quite aggressively with the result that an unexpected – and we suspect unintentional – monetary cliff occurs that leads the corporate bond markets to lose support. 

Such an event would both create higher borrowing costs for companies and less ammunition for the equity buybacks (and also the high dividend payments) that have been so vital in supporting the equity markets over recent years.

Similarly, we could also worry that the ongoing logjam in Congress persists and there is no fiscal easing and US GDP growth therefore falls below 2%, with all that would imply for not just corporate earnings but also investor confidence levels.

These US-specific worries are – at least according to our reckoning – relatively low probability events but much more likely in our view is that the continuing weakness in the Yen and consequent softening in world trade prices that this creates (given Japan’s still important role in setting world trade prices) leads to a wider outbreak of deflation within the global economy. This would not only sap corporate profits but we suspect that it would also undermine the markets’ belief in the effectiveness of central banks. Financial markets simply do not like deflation and history over the last 30 years shows that a weak Yen can be a highly deflationary force for the global economy and for the emerging markets in particular. 

Given this potential problem, we would argue that it is also not inconceivable that the more conservative factions within the Bank of Japan may rebel against the hyper-aggressive stance implied by Abenomics and instead decide to support the currency via a tighter monetary stance, even if this was at the expense of the local bond markets.

Unfortunately, given Japan’s still preeminent role as a supplier of savings to the global economy, we suspect that any sell-off in JGBs would presumably force a repatriation of Japanese capital from abroad that would in turn drive global yields higher to the obvious discomfort of the risk markets. Therefore, while a stronger Yen might defuse the threat from world trade price deflation, if it were to result from a repatriation of capital into Japan this could bring with it its own problems.

Another relatively high probability event that could unsettle markets is that the much prophesised and eagerly awaited Eurozone economic recovery simply fails to materialise, perhaps because the ECB’s expected easing either does not occur for political reasons or is ineffectual as a result of the ongoing tighter regulatory situation.  In fact, we would worry that, having been promised a recovery in 2014, Europe’s voters could react quite badly were a recovery not to occur and this would have deep and significant political dimensions.

Our biggest concern for 2014, though, is that China is ultimately denied sufficient access to the USD credit markets to meet its ongoing borrowing requirements and that it therefore becomes another emerging market with a pressing balance of payments problem.

Although markets have been slow to realise this transformation, it seems that China is now addicted to foreign borrowing (much of it via some of Hong Kong’s banks who have been acting as the intermediaries for these extremely large flows from the rest of the world into the world’s second-largest economy) but any drying up in the supply of foreign dollars for whatever reason could see China suffer a recession and Hong Kong might well suffer a banking crisis if the dollar shortage were allowed to become severe enough so that China – and its “agent” – suffered liquidity problems.

As we reach the end of what has generally been a profitable, if occasionally rather fraught, year for most investors, it is our feeling that markets will indeed try to rally further over the next few quarters and thereby attempt to repeat their 2013 performance, but we shall be watching the risk factors noted above (and particularly those relating to China, Japan & Europe) just in case the year turns out to be a great deal more complex than the bulls would currently have us believe.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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