"It'll probably never happen, BUT ......"

Monday 4th January 2016

"It'll probably never happen, BUT ......" 

Ref :- "Unlikely suspects are in the wings for 2016" , FT Weekend, p.14

Welcome to 2016, and it's not easy to find commentators prepared to offer firm predictions as to what the year might have in store beyond those following what might be termed the "herd" consensus. But if the committed mavericks are in short supply, the FT does offer an alternative view on some major issues that at the very least are worth considering. They're not saying that these prospective scenarios are likely, you understand .... only that they have been identified as so-called "tail-risks" during a survey of investors and analysts. The term "tail-risk" is applied to outcomes at the lowest end of statistical probability and for sure all of these projections should at this stage be considered "odds against", in book-making parlance. But whilst some are more unlikely than others, none of them seem out of the question to us and should definitely be incorporated into any risk analysis process. After all, the unexpected DOES happen ..... constantly. As the FT points out, at the start of 2015 how many market sages predicted that the Swiss would scrap their currency cap against the Euro ?

Anyway, try these on for size .....

1. A HARD LANDING FOR CHINA

No one would deny that China is facing a further slowing of growth, the question is by how much and at what pace? On balance, the market believes that China will achieve a soft landing but that's not to say that there aren't plenty of Cassandras about if you look for them. The word over the holiday period was that official Q4 growth would show a decline to 6.4% (from 6.9% Q3), though we've just had some pretty gloomy manufacturing surveys out today. You only have to remember August's market turmoil created by the authorities' decision to weaken the yuan / renminbi (taken as an unspoken admission of faltering growth) to realise just how crucial this issue is for the health of the global economy, and not just commodity-producing emerging markets. China is engaged in a process of shifting the focus of its economy away from investment in construction and infrastructure towards internal consumption of goods and services. At the same time, further easing measures to stimulate faltering growth will plainly be required. Getting such a cocktail right will not be easy, and failure to do so could have the severest repercussions.

2. THE RETURN OF INFLATION

You could easily make the case that rising rates in the US and easing measures in China will lead to capital outflows from the latter, and therefore weakness both in its own currency and those of other emerging economies. Such a picture would surely only prolong disinflationary pressures for the US and other importing nations. But there is a body of opinion that argues that seven years of central bank action to combat deflation and depression have put economies in a vulnerable position should inflation rear its head. In short, the Fed and others would be "behind the curve". The risk is that assumptions about a low-growth, low-inflation environment are just plain wrong. In fact, upward pressure on wages that may follow the fall in  US unemployment from 10% to 5% could engineer a rise in inflation even without significantly higher growth numbers. And if the Fed is behind the curve, then the markets are even further behind. Remember that they have consistently discounted the Fed's more hawkish forecasts (an eminently successful strategy up to now), and currently price in two rate hikes this year in contrast to the central bank's forecast of four. Essentially, what we're being warned about is that inflation has been a non-issue for so long, we're in danger of taking our eye off that particular ball just when we need to be at our most vigilant. Or, as Paul Lambert of Insight Investment put it, "It's like the wolf might finally arrive just as everyone stopped believing the little boy".

3. THE END OF CENTRAL BANK "INSURANCE"

There is plenty of justifiable concern about how the world (and its markets) has become so reliant upon and dominated by central banks. Huge bond-buying programmes have pushed down the cost of borrowing and boosted asset prices, in particular those of equities and property. In addition, capital has made its way from the near-zero interest regimes of the developed world to emerging markets in the search for better returns. But what happens now that the Fed has started to raise rates, supporting the dollar and in effect removing the security blanket that investors have become used to ? Central bank actions have (fairly) successfully supressed natural market volatility over a sustained period, and the end of this period naturally begs the question whether the resultant capital outflows from emerging markets can be handled in controlled fashion or whether some kind of crisis will ensue.

4. EUROPE ON THE UP ?

Here's a scenario that not many might have envisaged ..... the chance that Europe might even outperform the US in the second half of 2016. Blackrock's chief investment strategist Ewan Cameron Watt is not saying that such a result is likely, but does believe it is at least plausible given a certain set of circumstances. First of those would be that US growth undershoots projections, but on a more positive note it's possible that the European economy, already showing tentative signs of growth, is given a further boost by a huge expansion in government spending brought about in large part by the influx of refugees. It would certainly be nice to think that something positive could come out of such a tragic situation, but not everybody would be happy and particularly not the holders of government debt. They will already be a mite nervous after the ECB decided last month not to increase the size of its monthly bond purchase when it had seemingly given every indication that it would. If that proves to be the prelude to stronger-than-expected growth, assumptions that very low interest rates have become the norm will have to be reassessed, as of course will the wisdom of sitting on very large bond positions.

5. BREXIT

The elephant in the room as far as we're concerned in that, as you may have noticed, we've not really discussed this potentially huge topic at any length up to this point. That's really because the UK government is not committed to a referendum on a possible British exit from the EU until the end of 2017, and there's bound to be a lot of unhelpful and misleading "noise" between now and whenever the poll is called. But since it now looks possible that the vote could take place much earlier than that (conceivably as early as this summer), and some polls are now suggesting that the nation is split 50/50, we should at least consider some of the ramifications of deciding to quit the EU. The idea that the UK will be able to negotiate favourable trade deals that would negate the impact of Brexit looks flawed ..... it's all very well being a long-standing trading partner from the outside, like Norway or Switzerland, but if the UK was to pick up its ball and go home after 45 years it seems unlikely that the EU would be rushing to offer it the most beneficial terms. Would huge industrial employers like Nissan be happy to keep their plants in the UK if exports to Europe were suddenly to be subject to tariffs ? What would multinational banks with European headquarters in London do once London is no longer in Europe ? Could London maintain its status as THE European financial centre ahead of Frankfurt or Paris ? Can Scotland stay in if the rest of the UK pulls out ? As Citigroup chief economist Willem Buiter puts it : "If it goes wrong the British economy would vanish for the next ten years. And because it would create uncertainty about the EU unravelling, it's big enough to matter for the global economy."

Now that's a cheery thought to start the year off.