Following on the heels of Byron Wien, Morgan Stanley’s Surprises, and Saxo’s Outrageous Predictions, Deutsche Bank’s FX strategy team has created a who’s who of 13 outliers for 2013. Quite frankly, given the extreme nature of monetary (and now fiscal) policy, asset allocation decisions, and bankers’ and politicians’ willingness to go into the media and lie directly to our faces, the comprehension of the possible (no matter how improbable) is far more important for risk management than the faith in the centrally-planned unreality our markets (and therefore ourselves) currently find themselves in. As they note, all too often, the tendency to not stray too far from a self-anchoring recent-history-extrapolated consensus (while apparently highly profitable for some for a microcosm of time) leads to unrecoverable drawdowns exactly when career-risk was the limiting factor. From Malaysian elections and EM bubbles bursting to Fed monetizing equities and South China Sea escalation, these outliers seem all to ‘normal’ in our brave new world.
Via Deutsche Bank:
When thinking about the year ahead, it is tempting to extrapolate the recent past whether looking at risks or one’s base case. Moreover, there is a tendency not to deviate too far from consensus, perhaps seeing safety in being part of the herd. From a statistical perspective, this is very similar to assuming markets follow a normal or Gaussian distribution. That is, markets are well behaved and extreme outcomes are rare. The financial crisis of 2008 taught us otherwise, yet it is very difficult to shrug off the bias to assume normality in markets. We have therefore conducted an exercise within our team to think up 13 outliers or extreme events that could unfold over 2013. These are not simply the commonly cited risks to views, but events and occurrences that would genuinely surprise market participants; we underscore that these scenarios do not represent the DB base case. What we are trying to do is highlight outliers that are in the tails of the distribution. Our ability to predict outliers, by very definition, is limited, yet we hope the approach of assuming extreme events will be more common than we might think should provide the right mindset as we enter 2013.
1. Fed finances the purchases of equities
The Fed has consistently taken a more aggressive approach to easing since the 2008 crisis. Indeed, the most recent FOMC meeting introduced QE4 and quantitative thresholds for future policy – steps that were more than many had expected. The question is, what could the Fed do next? Finance the purchase of equities could be the answer. Indeed, one of the strongest market reactions to past QEs has been stock market rallies, yet that effect appears to have faded since QE3 in mid-September, as equities have not rallied in the same way. With the US housing sector apparently turning the corner, stronger equities may be the necessary tonic to further increase household wealth, and also to boost investment. Moreover, it is not unprecedented amongst developed-world central banks. The Bank of Japan under its current Asset Purchase Programme buys corporate bonds, ETFs and REITS. While the Fed does have restrictions on what assets it can buy, it can invoke Section 13(3) of the Federal Reserve Act that allows more extreme actions in “unusual and exigent circumstances”. One only needs to recall that the Fed created the Maiden Lane vehicle in 2008 to hold the risky assets of Bear Stearns that JPMorgan was not willing to hold to see what powers the Fed has.
Should this happen, growth and risk-sensitive currencies such as EM FX, dollar bloc and SEK should perform well.
Bilal Hafeez, London
2. Greece discovers gas reserves valued more than total debt
Greece has sizeable undersea terrain in the Mediterranean, and several Mediterranean countries have already discovered and are exploiting undersea natural resources, most notably the Levantine gas field between Israel and Cyprus. A number of studies that have looked at similar gas finds in the Mediterranean as a basis of comparison put the potential size of gas fields to the South of Crete as high as $600bn. These are not based on hard geological evidence, and the government has recently commissioned a seismic survey company to determine the potential magnitude of reserves. Preliminary outcomes are expected in mid-2013, with a potential positive find generating a rare positive surprise for the debt-stricken country.
Should this happen, EUR should perform well.
*’Greece looks out to sea for gas and wealth salvation,’ Reuters Newswires, 3rd October 2012
George Saravelos, London
3. Sweden, Turkey and Brazil work together to bring peace to the Middle East
In September, at the 67th UN General Assembly meetings in New York, Sweden, Brazil and Turkey launched a new initiative called the “Three soft powers from three continents”. The first goal will be to prevent assaults on sacred values. However, the foreign ministers of each country, Carl Bildt of Sweden, Ahmet Davutoglu of Turkey and Antonio Patriota of Brazil, have talked about their interest in helping solve challenges facing the international community based on their common values of dialogue, multilateralism and democracy. In the past, Brazil and Turkey have attempted to resolve the nuclear issues in Iran, while Turkey and Sweden have worked together on issues in the Balkans. As the three countries work more closely together on international issues, their attention could once again turn to the Middle East. Syria is the most pressing issue, but their focus could expand to other countries in the region. The foreign ministers next meet in Turkey in January.
Should this happen, ILS and EGP should benefit and oil exporters CAD and RUB suffer at the expense of importers INR, TRY
4. UK coalition government breaks up – election called
It is not widely anticipated by political analysts that the coalition government will hold until the end of the parliament term in 2015. Both the Liberal Democrat and Conservative parties will likely wish to have some time before the next election to distance themselves from the policies of their partners in the eyes of the electorate. This split could potentially occur as early as next year, with divisions over energy policy, parliamentary boundary changes, House of Lords reform and most importantly economic policy leading prominent party members to agitate for a split. Given that the parliamentary term is fixed, it seems the most likely outcome of a breakup would be a minority Conservative government that relies on informal Lib Dem support to pass legislation. However, if this were to prove unworkable, a vote of confidence could be called, which would lead to new elections.
Should this happen, GBP should depreciate.
Oliver Harvey, London
5. A 2013 race to negative depo rates and every major stock market in the world is up
It started in Denmark and Switzerland, with Japan following, and to avoid excessive currency appreciation, EUR and then the US could follow suit with negative rates. But there is another investment vehicle. Currently only Spain and China’s major equity indices are down in 2012. In 2005, China and Italy were the exceptions and were down, while in 2006 and 2009 there were no exceptions, with all 47 of the most liquid equity markets ending up on the year. With China widely seen as cheap, and EUR periphery risks dissipating, 2013 could be another year where every major equity market is up, aided and abetted by negative rates.
Should this happen, carry currencies should outperform.
Alan Ruskin, New York
6. North Korea opening/detente
Unconfirmed reports this year suggested new North Korean leader Kim Jong-un planned to push ahead with reforms, enabling capitalistic agricultural and industry reform per China in the 1970s and 80s. The start date was reportedly slated for October 1, but was pushed back by food shortages until after the one-year anniversary of Kim’s father’s death on December 17. China’s new leadership is also likely to push for more specific, tangible reforms, and they have plenty of leverage as North Korea’s trade dependency on China has risen from 52% in 2005 to 84% last year. Incoming president Xi Jinping has close ties with the North, and Kim Jong-un is expected to visit China and meet Xi as soon as January. Meanwhile, Xi has expressed hopes that China’s ‘strategic cooperative partnership’ with South Korea will develop further in ‘new political circumstances.’
Should this happen, KRW should appreciate.
James Malcolm, London
7. Iran turns less hawkish or more volatile
The Iranian presidential election is scheduled to take place on June 14th 2013 to choose a successor to Mahmood Ahmadinejad. While the list of candidates is pre-screened by the Iranian Council and the selection process is currently being tightened via changes to the electoral law, the election outcome still has potential to surprise. Indeed, Ahmadinejad himself was viewed as a political outsider when he announced his presidential bid as Mayor of Tehran in 2005, subsequently taking a hard-line stance on Iran’s nuclear program. Somewhat ironically, the changes to the electoral law are mainly opposed by the current president, who reportedly views them as negatively affecting a potential candidacy bid of his close ally Esfandiar Rahim Mashaei. Other potential candidates mentioned in the press include Tehran’s mayor Mohammad-Bagher Ghalibaf, the chief nuclear negotiator and a close ally of Khamenei, Saeed Jalili, and Ali Larijani, the parliamentary speaker. Some are viewed as more pragmatic on Iran’s nuclear program generating the potential for a softer foreign policy following the election, easing geopolitical risk in the Middle East next year. In the meantime, broader political and social uncertainty around the election cannot be ruled out, with Ahmadinejad’s 2005 re-election causing a wave of protests and riots that lasted into 2010.
Should this happen, ILS would likely be most sensitive, along with oil betas (CAD and RUB in particular).
8. Breakdown of FX/equity correlation
The spike in correlation between G10 FX and equities beginning in 2008 and lasting through the present is unprecedented in the free float era. Next year may finally see the breakdown in this correlation for three reasons.
1. Global yield compression and light positioning has unwound carry trades: FX positioning has been reduced in large part because carry-to-vol ratios were not compelling; currencies such as EUR and CAD were still behaving like risky assets, with high betas to the S&P 500, even though carry in these pairs had long disappeared. Volatility is finally falling in these pairs to match the low carry as there are fewer G10 positions to unwind and hence the beta (if not yet the correlation) to the S&P 500 is falling.
2. Real activity data is less correlated as recovery proceeds at different speeds: The fundamental driver of FX/Equity correlation is likely global synchronization of business cycles, most prominently in 2008-09. This correlation has been falling for several years as the US economy outperforms an austerity-led European recession and Asian growth increasingly drives $-bloc and Scandinavian economies.
3. Volatility and correlation are falling in other asset classes: Falling S&P 500 single stock correlation, historically closely related to FX/equity correlation, points to the declining influence of global risk factors on individual asset prices. A correlation breakdown would have positive implications for currency investors. They would regain access to a diversified basket of instruments, useful and effective in expressing views on relative monetary policy, independent of the global growth landscape. The elimination of high beta volatility stemming from global macro risks would reduce currency portfolio volatility and potentially improve returns as fundamental and momentum investors get stopped out of trades less often. Finally, reduced equity correlation would likely rekindle interest in FX as an asset class, now seen by many macro investors as little more than a trendless proxy for equity volatility.
Should this happen, FX should become more diversified.
Daniel Brehon, New York
9. South China Sea territorial tensions escalate
An increasingly assertive China, the US foreign policy pivot towards Asia, an ocean bed of potentially vast mineral reserves surrounded by fast-growing resource-hungry nations, disputed maritime boundaries, and fishing boats with tendencies to stray, all make for a combustible situation in the South China Sea. While a full-blown military conflict remains unlikely, a series of naval skirmishes in 2012 and creeping militarization in the region have bred suspicion and heightened tensions. Further provocation could begin to strain trade relationships in a region with highly integrated supply chains, dampening the exports recovery. It could also decrease (the potential for) intra-regional FDI at a time when the overseas investment push from Asia is increasing, and may also detract from the credit re-rating story underway in certain markets (i.e. Philippines).
Should this happen, all Asia FX including JPY should suffer.
Mallika Sachdeva, Singapore
10. Europe gets powered by solar
In theory, an area of the Saharan desert the size of Wales could harness enough solar energy to power the whole of Europe. The theory may eventually turn into reality thanks to initiatives like Desertec, a consortium set up in 2009 to harness solar energy from the Sahara. Desertec aims to provide 15% of Europe’s electricity by 2050. Solar and wind power projects have already started in Morocco. Importantly, in November of this year, Morocco, Germany France, Italy, Malta, and Luxembourg reached an understanding for the first joint project between Europe and Morocco. Spain’s absence from the agreement has so far prevented the agreement from being formally executed, but expectations are that Spain will sign. Admittedly, there are issues of funding and partners for the overall project, but meaningful advances on the project over 2013 could result in one of the more positive surprises of the year.
Should this happen, EUR should benefit.
11. Climate change risks begin to get priced
In March the Intergovernmental Panel on Climate Change (IPCC) published a report warning that global warming is already resulting in such extreme weather that governments should prepare themselves for a higher incidence of natural disasters. This admonition was brought home most recently by the devastation caused on the US East Coast by Hurricane Sandy. Accelerating climate change has a number of implications for financial markets and FX. For example, if the droughts in the US, Russia and Brazil continue next year as forecast, this could lead to knock-on effects for global food prices, one result of which may be pressure on central banks to tighten policy (our Asia strategists already identified SGD’s high beta to food prices for this reason in July). Natural disasters such as typhoons and hurricanes can have significant negative impacts on GDP and may weigh on the economic recovery. Finally, if markets begin to rerate potential future economic growth, or the longevity of certain energy sources, this could result in structural shifts in asset valuations.
Should this happen, FX vol should rise.
12. EM bond bubble bursts
The past few years have seen non-resident investors build up their positions in EM local debt markets to new record levels, driven by a broader global search for yield, monetary policy easing across major Emerging Markets and the healthy state of EM fiscal balance sheets. With few exceptions markets expect this trend to carry over into the new year. However, with output gaps typically limited, real rates at cyclical lows, and global liquidity abundant, EM economies will be sensitive to higher inflation, which could undermine the attractiveness of EM debt given that it is already unattractive vs. inflation expectations. Supply shocks, with higher food prices and/or crude triggering higher inflation would be particularly negative, and/or EM FX continuing to underperform would not only add to inflationary pressures but also undermine total returns of EM local debt. South Africa, Turkey, Russia, Brazil and Peru have the highest pass-through from food and oil prices to CPI and could end up yielding negative real rates in this scenario, which in turn could trigger substantial outflows.
Should this happen, EM FX should suffer and FX vol should rise.
Henrik Gullberg, London
Siddharth Kapoor, London
13. Malaysia government loses election
In Malaysia, elections must be called within the first half of 2013. Barisah National, the ruling coalition, lost its super-majority (two-thirds) for the first time in Malaysia’s modern history in 2008, and there has been a growing popular movement for electoral reform since. An upset by the opposition – although very unlikely by all public indications – could have a significant impact on economic policy (fate of the government’s flagship Economic Transformation Plan, tax policies) and would likely hurt the equity market with government-linked companies taking a hit. In India, while national elections are not due until 2014, the government – currently operating as a minority coalition – is dependent on drawing shaky support from a diverse group of regionalist, populist, and pro-/anti-reform parties. Support from the latter could slip amidst a series of state elections next year, prompting early elections. The ensuing policy vacuum and a dimmer/deferred outlook for reforms would likely drive off much-needed portfolio flows.
Should this happen, MYR should depreciate.
Source: Deutsche Bank