December 12, 2017 / 10:56 AM / 4 months ago

Bold calls and Black Swans - how 2018 may surprise you

LONDON (Reuters) - Central banks are slowly (but surely) turning off the stimulus taps and many markets are at record peaks, yet judging by the extraordinarily low volatility across most asset classes, investors don’t seem at all worried about a looming collapse.

FILE PHOTO: Euro and Dollar banknotes are seen in a picture illustration taken October 19, 2016. REUTERS/Leonhard Foeger/File Photo

That’s reflected in the outlook for next year. A flattening of the entire U.S. yield curve, a steep credit market correction and the U.S. unemployment rate falling to a 50-year low are among the more eye-catching, although hardly outlandish, official forecasts from big banks and funds.

More interesting are the “Black Swan” risks and events that would be far more significant, such as the Federal Reserve losing its independence, Wall Street plunging 25 percent and Bitcoin crashing to $1,000.

Below are some of the forecasts, plausible risks and Black Swan events that could shape 2018.

1. CREDIT MARKET CRASH

“The sword of Damocles is hanging over the head of the credit markets. After two years rallying, credit markets now look expensive on every metric.” So say credit analysts at French bank Societe Generale.

They argue markets have gone from averagely priced last year to very expensive now. Current ratings and default trends look pretty encouraging, but that will change as the year progresses as investors start to price in lower U.S. growth in 2019.

Two specific sectors are areas for concern: Chinese property market wobbles could turn into something far more serious, while U.S. tech firms are leveraged too high and rely too heavily on advertising.

2. ENTIRE U.S. YIELD CURVE FLATTENS

That’s what Morgan Stanley’s rates strategists are predicting - by September next year the yield on all U.S. bills and bonds out to the 30-year maturity will be no higher than the Fed funds rate of 2.00-2.25 percent.

They’re not predicting inversion, the harbinger of every recession since 1980 (their peers at Citi are, although they won’t say whether that will happen next year or beyond). Instead they note the parallels with late 2005 when growth was running north of 3.0 percent, the curve totally flattened and it was two years before markets and the economy rolled over.

Growth now is running north of 3.0 percent, the curve is flattening rapidly and is barely 50 basis points from zero. So perhaps it’s not too far-fetched, although few others are sticking their necks out that far.

The curve also flattened in June 1998, a full 18 months before outright inversion and the bursting tech bubble heralded recession in 2001. Will the current flattening peter out around zero? History shows that rarely happens.

3. U.S. UNEMPLOYMENT RATE AT 3.7 PERCENT

That’s the view of Goldman Sachs economists, confident that the labour market’s “impressive momentum” built up after nearly a decade of strengthening shows no sign of slowing. An unemployment rate of 3.7 percent would be the lowest since the 1960s.

At 4.1 percent currently, it’s already below levels that Fed officials view as sustainable, Goldman notes. “Our projections would imply an evolution over the current cycle from the weakest labor market in postwar U.S. history to one of the tightest.”

Given how tight the labour market is as the U.S. expansion heads into its ninth year, one might expect the unemployment rate to trough and start edging higher. But Goldman goes further, predicting that it will drop to 3.5 percent in 2019.

PLAUSIBLE RISKS

Analysts at Deutsche Bank have published a list of 30 market risks for 2018, both to the upside and the downside, that would probably spark an increase in volatility to varying degrees.

They are not part of their house view. Rather, investors should think of them as “potential VIX-boosters”, that is scenarios that should spur financial market volatility.

Many argue that the VIX index of implied volatility on Wall Street could do with some boosting. This year it fell to its lowest on record, and by some measures U.S. stocks have had their calmest year in history.

Below are three areas that cover some of Deutsche’s more eye-catching or plausible risks:

1. HIGHER INFLATION

Wage growth in the United States and Germany accelerates, forcing the Fed and ECB to tighten policy quicker than is currently expected. Tighter policy, higher rates and rising bond yields could be felt across all markets.

2. U.S. POLITICAL RISK

There are three potential triggers: the Mueller investigation into alleged interference by Russia in the 2016 U.S. election that helped Donald Trump win the presidency, the U.S. midterm elections, and a continued widening in inequality stoking increased voter disatisfaction and ultimately leading to more populism.

Any one of them has the potential to sour investor sentiment towards U.S. markets, potentially heralding a correction on Wall Street.

3. BREXIT

Two possibilities here. One, a UK general election delivers a new government. The Conservatives are voted out and Labour is voted in, meaning Jeremy Corbyn is prime minister.

Second, Brexit is reversed. This is far less likely but not completely impossible. Polls show a high degree of regret over the June 2016 vote to leave the European Union, and if Brexit negotiations continue along their chaotic path, don’t rule out completely a scenario arising that effectively involves a do-over.

BLACK SWANS

Strategists at Danish bank Saxo Bank have drawn up a list of “10 outrageous predictions” for next year which, if even one were to play out, would ripple like a tsunami across world markets.

These are extremely low probability/high risk events, and all 10 are listed below:

1. The Fed loses independence as the U.S. Treasury takes charge, enacting a 2.5 percent cap on the 10-year yield after a massive spike higher.

2. The Bank of Japan loses control of its monetary policy. Dollar/yen (currently 113.00) rises to 150.00 and then collapses to 100.00.

3. China issues a yuan-denominated oil futures contract. The “Petro-renminbi” surges, with dollar/yuan (currently 6.61) sliding below 6.0.

4. Volatility spikes on a sudden S&P 500 ‘flash crash’, and the S&P 500 drops 25 percent in a spectacular plunge.

5. U.S. voters push left in the 2018 mid-terms, bond yields spike, with the 30-year Treasury yield (currently 2.77 percent) rips beyond 5 pct.

6. “Austro-Hungarians” launch a hostile EU takeover, as the divide between old/core EU members and more sceptical/newer members widens to an “impassable chasm”, shifting the centre of gravity away from the Franco-German axis. The euro (currently $1.18) slides towards parity with the dollar at $1.00 after hitting new highs above $1.60.

7. Investors flee Bitcoin as governments strike back against the largely unregulated crypto-currency. Bitcoin (currently $16,500), plunges to $1,000.

8. South Africa booms after an “African Spring”, and the rand soars 30 pct versus emerging market currencies.

9. Tencent topples Apple as the most valuable company in the world. Tencent shares gain 100 percent.

10. Women take the reins of corporate power. More than 60 Fortune 500 companies end the year with female CEOs.

Compiled by Jamie McGeever Editing by Jeremy Gaunt

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