While moderate recovery in growth and inflation is BofAML’s rates team’s base case, there are numerous risks to that forecast. The risk of tapering is already quite well known and they suspect it may not result in the significant market-moving event many expect when it actually happens; however, the following downside and upside risks threaten BofAML’s central scenarios for 2014 as well.
1. Downside risk from US inflation
This is probably the most important risk the market is underpricing, in our view. We forecast US real GDP growth will accelerate to 2.6% in 2014 while inflation will continue to hover at current levels. With weaker fiscal headwinds, and the potential for the Fed to taper very gradually, we see a risk that the data may surprise to the upside. This could benefit EM via the trade channel. However, if the output gap narrows by more than commonly estimated due to lower potential growth or higher structural unemployment, US inflation could increase faster than we forecast. This would primarily impact the belly of the US and EM curves.
To watch: Growth improvements without a corresponding healing of the labor market could be a sign of a structural rise in unemployment. We would also watch long-run inflation expectations in the University of Michigan Consumer Sentiment Survey, core inflation readings, and wage growth data.
2. Upside risk from European inflation
Continued disinflation is a worrisome risk to the European economy in the coming quarters. In our Global Economics Year Ahead, our EU economists argue that the biggest risk to debt dynamics is persistently weak inflation. Worsening debt dynamics or fiscal slip-ups combined with uncertainty surrounding the banking exercise could reignite negative sentiment. CEE FX and yields would move lower. However, this may prove a trading opportunity. The ECB would likely respond with an LTRO to combat such weakness. Also, the ECB could turn aggressive with the LTRO, or even embark on weakening the EUR. Given these risks, we maintain a bullish HUF bias versus the EUR, and prefer to fund long BRL and MXN positions against the EUR.
To watch: CPI readings and fiscal performance in the periphery, particularly in Spain given the relatively large primary deficit, should be a focus. Also look for shifts in the ECB’s stance on extraordinary measures; we are already seeing some of this with the discussion of negative deposit rates.
3. Downside risk from China hard-landing
We expect growth to pick up slightly in 1H14 before moderating in 2H14 and then again in 2015. This will require fine-tuning from the authorities, balancing still ambitious growth targets with the planned shift in the composition of domestic demand towards consumption. Doing so, while reining in the property sector, may be no easy task. A sharper deceleration of growth would impact commodity prices negatively. Exporters like Brazil, Argentina, Peru, South Africa, Indonesia and Colombia would be hurt. ZAR could be most at risk given the continued current account concerns.
To watch: Pay attention to sharper rhetoric from authorities regarding the property sector, especially after the raising of minimum down payments in Shenzhen and Shanghai. Also, our ChinaLEAP indicator (MECILEAP Index <GO>) and credit data should provide leading information on activity.
4. Mixed risks from the BRIC election season
There will be important elections in two of the BRICS in 2014: Brazil and India. Both are in great need of fresh thinking to enact much-needed structural reforms after growing evidence of slowing potential growth (see GEMs in Focus: On surfers and workers). In Brazil, the polls suggest the risk of an opposition victory is very low, certainly lower than what we believe it is on the basis of the country’s relatively poor economic performance. An opposition victory would likely result in improved policy management and faster implementation of structural reforms.
In India, there is some risk of a hung Parliament, where neither national party is able to form a government. If this materialized, it would likely exacerbate pressures on the INR due to the continued threat of political instability and a lower chance of structural changes, especially in the infrastructure sector. Alternatively, a strong and decisive outcome with a stable coalition government led by either national party could benefit the INR, one of the most undervalued currencies according to Compass (down 13%).
To watch: Watch out for the evolution of polls in both countries. On 8 December, state poll results in India will be released. Then, national elections will take place around April/May 2014; Brazil’s presidential elections will be in October 2014.
5. Russian bear comes out of its cave
We see some chance that President Vladimir Putin will decide to reshuffle the government and/or push much-needed reforms in order to spur the stagnating economy, despite possible high political and social costs. An ambitious privatization agenda and improvements in the investment climate would fuel capital inflows, supporting EXD and LDM. Less positively, “reforms” could also take the form of tighter supervision of businesses and even greater state control of the economy.
To watch: Any government reshuffle could be a sign of impending changes, with personalities of new government officials most likely setting the direction of the change. The likelihood of changes will most likely increase after the politically important Winter Olympics in February.
6. Brazil gets ratings downgrade
S&P already has a negative outlook for Brazil and we believe a ratings downgrade could be coming next year. It is still unclear whether government efforts to curb public lending will be sufficient to contain fiscal risks. As we pointed out in a recent Brazil Viewpoint, the structural fiscal dynamics are still expansionary, and this may force the central bank to hike rates more than what we currently forecast. In other words, the current fiscal policy may prove inconsistent with Bacen’s objective of lowering inflation. Although Selic futures price in more hikes than we forecast, it is for these reasons why we view the riskreward as unattractive and prefer to stay square.
To watch: Pay attention to the evolution of the primary fiscal surplus and whether this converges on the target of 2.3% of GDP from 1.6%, and whether authorities actually follow through with their intentions to slow public lending in the face of weak growth
7. Tail risks to the Mexican reform tiger
Everybody loves Mexico, but there is a risk that the disappointment with the fiscal reform extends to the restructuring of the energy sector, which we expect to be enacted in 2013-14. Our base case is for the reform to constitute a productivity-enhancing game changer for the country. We see both upside and downside risks. The reform could allow production contracts for the riskier projects as well.
On the negative side, the reform could prove insufficient to entice foreign oil companies and open up the sector, which would have a large negative market impact. An upside surprise is more likely than a negative one, in our view, but the latter would have a more significant market impact. Prospects of lower foreign direct investment flows would weigh on the MXN, which is one of our top FX picks next year (vs EUR).
To watch: We expect constitutional changes to be approved by 15 December while secondary laws may not be approved until 1Q14. The devil will be in the details of implementation with respect to private sector participation through profit-sharing contracts, the lowering of Pemex’s fiscal burden and private electricity generation.
8. Geopolitics rears its ugly head
Saudi Arabia and Israel may become increasingly worried about Iran in the next six months, possibly even resorting to tactics that would shake the region’s stability. Beyond the interim period, the deal may not live up to expectations given what appears to be little commitment at the top level in Iran. Therefore, medium-term risks to oil prices will remain.
Countries with relatively higher shares of energy in their CPI baskets could have upward pressures on their local curves if prices tend to adjust rapidly (e.g., Chile, CEE, Turkey or India), or to their CDS curves if governments tend to take the brunt of the adjustment (e.g., Indonesia).
To watch: It will be important to see how domestic politics in Iran change over the next six months with respect to the deal, as well as the stance of the other regional powers, Israel and Saudi Arabia. Actions by the US Congress could also derail the process.
Global sentiment could sour if tensions escalate between China and Japan over islands in the East China Sea. Japan and the US have yet to comply with the Chinese introduction of an air zone around the islands, which leaves room for tensions to escalate. The latest developments increase the risks for error and misjudgment, but the market is unlikely to increase the risk premium for now. There are risks that this may spill over into retaliatory economic policies (trade, investment, tourism).
To watch: The US recently tested China’s air defense zone and further US involvement could prevent some escalation by reducing the boldness of some hawks in China.
9. FX mortgages lawsuits in Eastern Europe
Lawsuits against banks on FX mortgages have appeared in several Eastern European countries, introducing new uncertainty on potential future compensation costs for banks but also providing the opportunity to reach a final resolution to the legacy stock of FX loans. In Hungary, the Kuria, which is the highest court, is due to give guidance on FX loans validity (outstanding stock US$17bn) and whether unilateral changes to the contract conditions should be permitted.
To watch: The Kuria will start the debate on 16 December. The completion date is unclear, but the government will announce its final relief package for FX borrowers as soon as the ruling is announced. The government is aware of the importance of preserving financial stability, and we believe it is unlikely to opt for an immediate and extreme resolution, even in the case of a harsh ruling from the court (i.e., immediate conversion in HUF at a preferential rate). However, the court ruling may provide legitimacy to drastic solutions that may be implemented over the course of several years. The Hungarian case may also prove to be a template for other countries with widespread FX loans.
10. Faulty bailouts
Ukraine can play contradictions between the EU and Russia for too long and end up with nothing after all. The country can fail to secure timely IMF funding early next year for political reasons (just as it did over the past two years), as well as fail to get any new loans from Russia without full membership in the Russia-led Customs Union (the key condition from Russia). As a result, domestic financial markets can destabilize, triggering a renewed currency run from the population in such a scenario. The latter could push the National Bank of Ukraine’s reserves below critical levels and force disorderly UAH devaluation and/or default.
To Watch: Be aware of NBU FX reserves dynamics. We estimate US$15bn (US$20.6bn as of 1 November) as a critical level, with reserves below it potentially forcing FX policy change. Any Ministry of Finance success in rollover of the FX debt can help to keep reserves above this critical level.