Hazards that Could Derail the Rally in 2014

Source: FT.com

Like Christmas decorations, which appear in the shops ever earlier in November, the investment community is rushing to publish its forecasts for the new year with weeks of 2013 still to go.

Those predictions are themselves predictable. They are positive. Coming from organizations which sell investments, this is not a surprise.

Less predictable is that the cozy consensus is stronger than usual. With only a few exceptions, this is the base case that the investment community says it expects in 2014: The world economy will log its best year since the crisis, as crisis conditions finally recede into the distance. The process of post-crisis normalization will start in earnest, with the start of tightening by central banks, and a return to capital expenditures by companies.

This normalization means that investment returns will not match this year's results — U.S. stocks, in particular, have already priced in a recovery, higher rates will mean lower returns on stocks, and higher capex will eat into margins. Nevertheless, the process will proceed smoothly, with central banks, led by the Federal Reserve steadily applying the pressure, and rates rising a little in response. China will grow at only a slightly slower, more sustainable pace; Europe will grow at a painful and anemic rate, but at least it will be growth.

This is not a bad base case. It is more likely than many other scenarios. And those who guarded against this year's many risks will have missed out on the party in U.S. stocks.

However, I still suggest asking: What could possibly go wrong? Many terrorists around the world want to stage another event like 9/11, while the world's tectonic plates may shift to create a new earthquake or tsunami. I cannot begin to quantify the odds of these things happening. But here are some of the risks that we can envision:

Deflation in Europe

The consensus is calling for growth of about 1% in the eurozone economy next year, with benign inflation. It would not take much to miss these targets. A further year of stagnation would test voters' patience, while deflation would make it all the harder for peripheral countries to work off their debts, by effectively making the debt more expensive.

There are good reasons for optimism that a resurgence of crisis can be avoided. Foreign speculative investors are largely absent and the European Central Bank has credibility; deflation in Europe would put them to the test.

Abegeddon

An investment in Japan did very well this year, but what if "Abenomics" — the policy of aggressive monetary policy designed to bring back inflation — does not work as intended? Alex Friedman of UBS, who coined the term, suggests that Abegeddon could await if Japan succeeds in sparking inflation, but not growth. In such an environment, the hugely indebted country could see a collapse of confidence in its bonds

A bona fide financial crisis would set the cat among the pigeons. It is not likely, but few have it in their projections at present, making it that much more dangerous if it were to happen.

Wobbly BIITS

An acronym that made a brief appearance this year, BIITS stands for Brazil, India, Indonesia, Turkey and South Africa — large emerging markets with significant current account deficits whose currencies suffered sharp losses when the Fed threatened to taper off its support for markets.

This had the effect of pulling cash back to the U.S., and exposing those countries, chiefly the BIITS, that most needed it.

The problem eased somewhat when the Fed decided not to taper — although the Indian and Indonesian currencies have recently touched fresh lows for the year. The cozy consensus is that this will not happen again when the Fed goes through with tapering. Reasons for this confidence are unclear.

Peaked oil

The oil price has been a source of remarkable stability for three years now, with Brent Crude trading in a tight range around $110 per barrel. It has achieved this despite sharp falls in production in countries like Libya (thanks to civil disruption), Iran (thanks to sanctions) and Iraq, mainly because the ongoing shale gas revolution in North America has put downward pressure on prices.

Shale is not going away. But at present, it looks like Iranian exports should be coming back. Increased production from Libya and Iraq also seems likely. There is a decent chance, little discussed outside the oil market, that Brent could take a sharp dive well below $90. This would help many companies make money, and ease pressure on consumers. It might have more negative consequences on countries that rely on oil exports, such as Russia.

Accident in the treasury market

This was probably the greatest risk entering 2013, and once bond yields rose sharply after the Fed started talking of tapering, it nearly came to pass. Bond yields doubled, to touch 3%, in short order. They remain close to those highs.

A gentle rise in bond yields as the economy normalizes would be healthy. A swift rise towards 5%, as the market overreacted to a Fed announcement, could put everything else at risk.

Burst bubble in China

Finally, the world's second-largest economy continues to have property bubbles in many major markets, and a huge overhang of credit, as its leadership attempts to retool the economy. It is some decades since any money could be made by betting against China, but the risks remain.

A common theme, both to the cozy consensus outlook and to this list of risks, is that the world is in a delicate balance. This year, the economy and the monetary authorities kept in balance. The odds are that they can repeat the trick in 2014.

But those odds are not overwhelming. It would be sensible to insure against the risk that things do not pan out as well as they have done in 2013.

(c) 2013 The Financial Times Ltd.