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Are we being too optimistic? What could derail
our sanguine view of equity markets over the next
12 months? That’s a question the more bullish
investors are clearly asking themselves too.
We can think of four main risks:
The obvious one: Double dip. If the US or
Eurozone were to drop back into recession,
emerging markets would not avoid the fallout.
This would likely trigger capital
repatriation by risk-averse Western investors,
a slowdown in growth in China and the rest of
Asia, and damage to the emerging market
businesses of Western companies which have
been bolstering their profits. But, even though
our economists are cautious on the economic
outlook, they see low risk of a double-dip.
Recessions are usually caused by a sharp rise
in the household savings rate: since this has
already risen to 6.5% in the US, it seems
unlikely to spike higher. And the low level of
activity in the US, as shown most
dramatically by housing starts (Chart 5),
makes it unlikely that activity could fall
sharply again. A period of semi-stagnation is
more likely as the worst-case.
Conversely, the risk of growth surprising on
the upside might be more damaging. Suppose
that, in six months’ time, US GDP growth in
2011 was shaping up to be 4.5%, not the current
consensus of 2.4%. The market would worry
about when the Fed would withdraw QE and
even raise rates. Remember February 1994
when an unexpected Fed tightening caused the
bond market to crash. Perhaps more likely is
German growth continuing to come through
strongly, which might lead the ECB, under a
new German president – and ignoring the
shrieks from the periphery – to raise rates.
Combined with a currency war, that sounds
worryingly like 1987, when a German rate rise
in August triggered Black Monday on the
world’s stock markets in October. If the risk of
growth surprising on the upside sounds
fantastical, bear in mind (1) how little it is
expected, and (2) the UK Q3 GDP number
announced this week which, for the second
quarter running, was double expectations.
Another financial sector blow-up. Investors
remain concerned about losses still hidden in
the banking system in the US and Europe. We
got many fewer questions on European
sovereign debt, and on capital adequacy rules
than on previous marketing trips. But the
scandal over foreclosures in the US (where
some banks seem to have rammed through
thousands of foreclosures without the
necessary checks) worries many investors. To
us, the risk is less that banks will face further
write-offs because of this (although a
moratorium or tighter controls on foreclosures
would increase losses to a degree), rather that
a seizing up of the property market would
delay its finding a clearing level.
Currency wars and protectionism. It is very
hard to predict the likely outcome of the
current spat over competitive currency
devaluations. It seems unlikely that next
month’s G20 meeting in Seoul will produce a
solution. The US proposal to force countries
with a current account surplus or deficit of
greater than 4% of GDP to change the value
of their currencies seems highly impractical.
Look at the number of large countries which
exceeded this limit last year (Table 6). Failing
a G20 solution, what if after the mid-term
elections the US Senate passes a bill allowing
import tariffs on Chinese goods? Would
President Obama veto it? If not, the row
between China and the US could turn very
nasty. Since this would be in neither side’s
interest, we think this unlikely, but it is a risk.
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