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Risk Factors - April 2016

The table below presents 11 risk factors with probabilities assigned. It also develops the most credible market impacts.

 

April 2016

RISK PROBABILITY

What if the Fed took the wrong turn?

ANALYSIS:

The misinterpretation of the Fed’s decisions remains a major risk factor. The Fed may well be cautious, and the differences of opinion within the committee had increased with the appearance of new relatively hawkish voting members. For several years now, central banks have made a practice of preparing financial markets and economies for changes in monetary policy.  But the reversal of an ultra-accommodating monetary policy that has been in place for seven years carried particular importance. In our assessment, there is no pressing need for tightening or any type of monetary policy normalisation at this point. This view is at last largely shared, including amongst Fed governors (as hawkish members recently turned more dovish, and the recent statements by Janet Yellen point in the same direction). The Fed must avoid a communication error. Markets could react poorly if rates are increased prematurely, excessively or without a sound rationale.

MARKET IMPACT:

Count on a sharp downturn in equities and on contagion into the emerging markets, which have already been weakened. Such a situation would widen spreads and rates between Europe and the US, and further weakening the euro, two arguments in favour of European risky assets.

15%

Hard landing by the Chinese economy

ANALYSIS:

China’s business model has changed in the past decade. Growth is not as export-led as it used to be, and internal demand became te key driver for growth. Such a good move has some drawbacks: lending is excessive, debt is ballooning, industrial competitiveness has eroded, productivity gains are falling and potential growth is down. The question is not whether future and potential growth will be lower. That is already a given. Rather, it is whether growth risks falling sharply (and far) below its potential (5% at present vs. 10% 15 years ago)—in other words, whether China will experience a large-scale economic crisis. A more severe contraction of Chinese growth would add to an already long list of global deflationary pressures.

MARKET IMPACT:

Such a scenario would have a very negative impact, and its cascading effects would be especially disastrous: vulnerability in the banking systems, vulnerability in the financial system, vulnerability from China’s public and private debt, impact on commodities and emerging countries, impact on the currencies of commodity-exporting countries, advanced countries, and emerging countries... The Fed would cut its "tightening cycle" short, and the ECB would pursue its QE.

20%

Collapse of global growth

ANALYSIS:

A "hard landing" by the Chinese economy would mean a plunge in global growth, but other causes are possible. The continued decline in commodity prices and global trade, an excessively restrictive US monetary policy, and the structural weakness of European economic activity are all stirring fears of a decline in global growth. We (Amundi) are, despite major revisions from banks and international organisations, less optimistic in terms of growth forecasts than the consensus. The risk here is an even worse scenario, because it is about a dramatic slowdown in global growth. China would no longer be a source of confidence. Until now, the slowdown in the emerging world has been a tangible reality, while the "advanced" world has been moving forward for a few years now. Another slowdown in the “advanced world” could come from the secondary effect of the EMG countries (drop in exports), another dip in investment, jobs... in short, from domestic demand, at present the key driver for growth.

MARKET IMPACT:

Putting aside the use of expansionist economic policies, we may fear the return of a currency war, among the emerging countries on the one hand, and between the advanced and the emerging world on the other. Expect a dramatic underperformance by risky assets, equities, and credit.

20%

A recession in the United States 

ANALYSIS:

We have mentioned on numerous occasions that the market consensus was too optimistic, and that we have recently witnessed widespread growth revisions for a number of countries and regions, including the United States. For our part, we revised our growth outlook in 2014, and we are anticipating growth of around 2% in 2016 and 1.8% in 2017 (the current level of potential growth). As for the United States, we must not forget that consumption (which represents more than 70% of GDP) continues to hold up well and that there is a big difference (which has often proved unsustainable over time) between the services sector (strong) and the manufacturing sector (weaker). The key issue is knowing whether or not this will be sustained. Leading indicators continue to argue that growth of approximately 2%, not a contraction, is in the offing. At this time, a recession in the United States is not a possibility, but what is worrying is the Fed's lack of room to manoeuvre, as it has been unable to raise rates until now. The current situation is totally different from 2004-2006. During those two years, the Fed managed to hike interest rates 17 times—a total of 400 basis points—giving itself leeway, which it was quick to use once the financial crisis hit. Today that context is very remote. The Fed is behind in its economic cycle and financial stability, and to a lesser degree the US dollar, cannot afford rate hikes. How can the current slowdown be managed? Does the Fed still have credibility?

MARKET IMPACT:

A recession in the United States would be catastrophic for the global economy, and Europe, despite being in better health, would not be spared the impact. Short rates would remain low for a very long time and the Fed, with no leeway in terms of conventional monetary policy, would have no choice but to go ahead with QE4. Do not expect a positive impact on risky assets. The initial impact will be negative, and the lack of credibility of central banks would certainly add volatility and stress. Expect further, and substantial, budget imbalances.

20%

Sharp devaluation of the yuan

ANALYSIS:

analysis For a few days in the middle of last August, China gave the impression that it was abandoning its exchange rate policy, preparing the markets for a major depreciation of the yuan (in 1994, it devalued the yuan by 30%). These same fears reared their heads again in early January. Until now, China has used monetary policy, budgetary policy, fiscal policy, and revenue policy as stimulus tools, careful not to use the exchange rate policy. Moreover, it promised the G20 it would not, while the yuan will be part of the SDR starting October 2016. Beyond the very negative immediate consequences on the financial markets, such a decision (an abrupt devaluation of at least 10%) would, without a doubt, be interpreted as an admission of weakness in terms of the economic policy as a whole. A low probability, because China has clearly demonstrated its desire—and ability—to stabilise the currency vs. a basket, instead of preparing a vast devaluation. A moderate risk, but with potentially very great harm.

MARKET IMPACT:

In this type of scenario, expect a widespread downward movement in the markets. A surprise devaluation would be the start of a more intense currency war, especially in Asia. Monetary policies would become extremely accommodating to keep currencies from appreciating. A blow to the euro, and to the European economy, because EMG currencies make up more than 70% of its effective rate.

10%

Continued slowdown in the emerging economies (commodity prices fall again)

ANALYSIS:

Falling commodity prices, the dip in Chinese growth, and the coming shift in US monetary policy are all factors that are raising fears of a repeat of the 1997-1998 crisis (when emerging markets collapsed across-the-board). We should remember that emerging markets have been under stress since the US ended its QE programmes. Until now, only Asia had been able to withstand that stress, driven by the strength of the Chinese economy and its ability to curb difficulties. Corporate defaults and leading activity indicators have occasionally put the markets on high alert, but the resources brought to bear by Chinese officials (cuts in interest rates and in mandatory banking reserves, injection of liquidities, fiscal and tax measures, maintaining currency policy, etc.) ultimately put everything right. Now things are more complicated. Growth forecasts are being revised downward at regular intervals, and the risk is that domestic demand will unravel and economic policies will remain ineffective.

MARKET IMPACT:

This scenario would be a continuation of the trends seen at the beginning of the year, only worse for a number of emerging markets. Even though the drop in oil prices is a plus for commodity-consuming advanced countries, it is hard to believe that these countries would be totally isolated. With the decline in commodity prices, we should count on the continued decline in EMG currencies as well as capital flows out of the EMG. Choose asset classes from the advanced countries, and safe havens.

20%

A new European crisis

ANALYSIS:

During last summer’s Greek crisis, strong disagreement emerged with regard to the economic governance of the Eurozone, the need for stimulus, the adoption of reforms as a response to the crisis and even the role of the ECB. The limitations of the European institutions were once again laid bare. One of the main reasons is that such crises—and their solutions—were simply never foreseen (or foreseeable) in the European treaties, and the "dogma of convergence" did not prepare the institutions for such risk scenarios. The task now is to respond to challenges like Europe’s governance deficit, the lack of coordination in budgetary policies, the failure of supervision of budgetary imbalances, competitiveness gaps between countries, the unfinished nature of the mechanism meant to support countries facing difficulty and the failure to appreciate the interdependence of member states (while the ECB’s anti-contagion mechanism has evolved significantly, the same cannot be said on the budgetary front). In short, the illusion of convergence needs now to be addressed. A new European crisis, if it were to occur, would be fatal, unless there is a great leap towards federalism. Unfortunately, the discussions around the concessions granted to the UK do not point in this direction. These concessions have tempted other EU members, which have voiced their views loudly and clearly. Federalism vs. Europe “à la carte” vs. EMU breakdown… three very different scenarios.

MARKET IMPACT:

The negative impacts are all too well known: widening of sovereign and credit spreads, rise of volatility—only this time it would certainly be accompanied by a severe weakening of the euro. A new European crisis could very well confirm the scenarios of the zone breaking apart, or, at the very least, the weaker countries exiting it… unless the exit scenario tempts the most solid of them, which is highly plausible, because they will end up becoming tired – from a political standpoint – of economically and financially supporting the struggling countries.

5%

Liquidity crisis

ANALYSIS:

Aside from the risk scenarios outlined above, which could lead to the liquidation of positions and/or portfolios, it is worth recalling once again that the prevailing liquidity constraints call for additional caution. Since the 2008 financial crisis, the decline in investment banks’ inventories, the regulatory constraints that have led major players to buy and retain large volumes of bonds, the reduction in proprietary trading and market-making activities and the domination of central banks through QE programmes have all "drained" the fixed-income markets, and closing a position or portfolio now requires more time (seven times longer than before the financial crisis of 2008 if we are to believe the Bank of England). Even though bid-ask spreads have tightened since the financial crisis (due to the drop in interest rates), tradeable volumes are down sharply, as is the speed of execution, two major reflections of liquidity—or the absence thereof.

MARKET IMPACT:

This needs to be incorporated into investment decisions and should be taken into account in portfoliobuilding constraints and stress tests. Expect exit or macro-hedging plans for the less liquid portfolio segments or those that are likely to become less liquid in a crisis.

20%

The financial markets misjudge their long-term rate forecasts

ANALYSIS:

This risk materialised, with 10 Yr bund yield back to 0.15%, 10 Yr JGB in negative territory and US 10 Yr also down. The markets have tended to systematically predict too many increases over the past three years, particularly when it comes to the United States. The end of the financial crisis, the recover y of economic activity and the anticipation of monetary policy tightening or inflation are the factors generally put forward in favour of such projections. However, potential growth is lower, the economic recover y is less robust than in previous episodes (investment is insufficient, the labour market remains too weak, wages are not rising enough, weak productivity gains…) and it is still too early for monetary normalisation. Furthermore, the excess of global liquidity is not about to dry up. Japan and the eurozone have not completed their quantitative easing programmes. The rate policies of China, India and many other countries remain expansionary. The Fed will remain cautious and the Bank of England is not close to adopting a policy of monetary tightening. And even if we assume that budgetary deficits are not closely tied to long-term rates, the widespread reduction of public deficits calls for maintaining long-term rates at low levels. Finally, the deflationary pressures are still very real, with weaker global growth, a decline in global trade, a drop in commodity prices, lower inflation and industrial prices that are stagnant at best.

MARKET IMPACT:

There are powerful factors keeping long-term rates low, and the significant "repricing" of projected long-term rates could continue, especially in the US, where it seems to us that expectations of rate increases are still excessive, and growth forecasts too optimistic. In other words, yield curves could remain flat longer than expected.

70%

Political and geopolitical risks

 

ANALYSIS:

Politically and geopolitically, the markets are now operating against a difficult backdrop: Syria, Islamic State, terrorist attacks and migrant flows are some of the forces weakening diplomatic ties among countries, especially in Europe. And the political situations in certain countries like Brazil and Turkey are not doing anything to ease the climate. The States’ commitment, and most importantly the type of commitment, in the fight against Islamic State are currently under debate, and this will probably be the case in 2016. Renewed tensions between Saudi Arabia and Iran exacerbated this feeling of insecurity in early January.

MARKET IMPACT:

There is no doubt that there will be regular spikes in tension and volatility. The current political risks are clearly identified and specific, but will this be enough to impact growth prospects or orientations on the financial markets? Nothing is certain at this stage.

70%

Brexit

 

ANALYSIS:

United Kingdom (England, Scotland, Wales, and Northern Ireland) will vote for or against an exit from the European Union on June 23. An exit would represent an economic risk for UK: according to some estimates, UK would “lose” between 2.5% and 9.5% of its GDP. Trade volume and costs would be affected, specifically in financial services, chemicals, and automobiles, all sectors that are highly integrated in the EU. Easy to understand why most businesses plead against any Brexit scenario. Note that a Brexit would not impact too much the EU, economically speaking (hardest hit would be those with close ties to the UK, especially Ireland, but also Luxembourg, Belgium, Sweden, Malta, and Cyprus). There is a political risk for the EU behind the Brexit: some EU members might be tempted to negotiate options with the rest of Europe (immigration, sovereignty, governance…). We do not have an outlook on the result of the referendum, as the opinion polls do not provide any assurance. Undecided voters will ultimately have the last say, and the outcome might hang on the persuasiveness of the leaders of the opposing camps.

MARKET IMPACT:

In the event of Brexit, and especially in case of a "hard exit" (end of trade agreements, end of the European passport for corporates…) we will see an additional weakening of the pound sterling and long-term GDP of the British economy, two factors that could prolong the monetary status quo: 50% of UK exports go to the European Union.

50%

 

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Cross Asset of April 2016 in English

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ITHURBIDE Philippe , Global Head of Research
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Risk Factors - April 2016
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