“Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be,” Lord Keynes cautioned in The General Theory of Employment, Interest and Money, “and this national weakness finds its nemesis in the stock market.”
This American freely confesses to an undue interest in average opinion on markets. Indulging this curiosity, as I do twice a year, in December I polled three dozen global macro hedge fund traders and strategists for their opinions on six key issues that will determine market outcomes in 2014. These issues represent some of the most pressing economic and political challenges facing global leaders today. They will be at the center of debate when chief executives, major investors and politicians gather for the annual World Economic Forum in Davos, Switzerland, beginning January 22.
At the top of the list, not surprisingly, is the Federal Reserve Board. Will the U.S. central bank and its incoming chair, Janet Yellen, execute a smooth taper of its bond purchases that brings long-term rates up to a 3 percent to 4 percent range without deflating the Dow? Elsewhere, will one or more emerging-markets countries — especially one of the so-called fragile five of Brazil, India, Indonesia, South Africa and Turkey — go through a balance of payments crisis? Will violence in Syria or an unraveling of Iran’s nuclear deal spill over into a Middle Eastern oil supply shock that pushes Brent back up toward $120 a barrel? Will Abenomics ignite sustainable economic growth in Japan and end deflation? Will one of the peripheral countries in the euro zone suffer a big sovereign write-down, or will financial and fiscal integration continue in the now 18-nation bloc without any hiccups? And finally, in China will President Xi Jinping’s reforms, announced at the Third Party Plenum in November 2013, succeed in rebalancing the economy and pushing the country’s growth rate into soft-landing territory, below 7.5 percent, this year?
Weighty questions, one and all. And the average weight of opinion among this elite group predicts the following:
- It’s a 70 percent bet that the yield on ten-year U.S. Treasuries will normalize above 3 percent, with a smooth taper that leaves the Dow Jones industrial average above 18,500 by year-end, compared with a January 17 close of 16,458.56.
- A 43 percent probability of a balance of payments crisis by one or more of the fragile five, with Turkey and South Africa the most vulnerable.
- Brent will trade between $100 and $120 a barrel (46 percent likelihood), with a one-third bearish chance the price will fall below $100 (it was $106.32 on January 17), reflecting a belief that the risk of a Middle Eastern supply shock is low.
- Abenomics will prove partially successful, with Japan’s consumer price index rising between 1 percent and 2 percent (47 percent probability) and gross domestic product expanding by 0.5 percent to 2 percent in real terms (57 percent), although there are several political tail risks.
- Sustained euro zone financial integration (82 percent chance), with a very minor risk of default by a peripheral country (13 percent).
- A one-third chance that China will achieve GDP growth above the official target of 7.5 percent, with a small chance that it will fall into the sub–6 percent hard-landing zone (17 percent).
Let’s begin with the U.S. In the middle of 2011, the chances that the Obama administration and Congress would hammer out a fiscal compromise were 2 out of 3, according to my group of traders. A year later those odds had dropped to slightly better than even, at 55 percent, albeit with a rather large standard deviation of 21. By spring 2013 the odds assigned to a fiscal grand bargain, as some called it, had fallen to 35 percent, with an even smaller deviation of just 15. The flip side of traders’ skepticism about fiscal compromise by Washington was a grudging acceptance that the Fed would pursue a very dovish monetary policy for a prolonged period.
In 2014 the single biggest question in the U.S., one with substantial ramifications around the world, is how quickly interest rates will normalize to higher levels in response to the Fed taper and stronger economic growth. The second, related issue is what those higher rates (and reduced liquidity) will do to the prices of stocks and other assets, whose spectacular performance in 2013 is widely attributed to the Fed’s ocean of liquidity.
A year ago traders were obsessed with warnings of a “fiscal cliff” and the fiscal drag that federal budget sequestration would have on growth. They were deeply pessimistic about the prospects for a grand compromise in Congress.
As it turns out, the 65 percent average bet of no compromise in 2013 was correct until mid-December, when it suddenly turned wrong following the budget deal struck by Republican Representative Paul Ryan of Wisconsin and Democratic Senator Patty Murray of Washington. Sequestration turned out to be a more modest drag than had been expected, and the U.S. budget deficit shrank much faster than expected, thanks to the sequester and larger-than-expected tax receipts. The Congressional Budget Office originally projected the deficit for fiscal 2013, ending September 30 of that year, at $880 billion, or 5.3 percent of GDP. The actual deficit for fiscal 2013 came in at $680 billion, or 4.1 percent of GDP, and the CBO in September projected that the deficit would range between 2 percent and 3 percent for the rest of the decade.
With the Ryan-Murray deal in the bag, traders’ collective gaze has left Capitol Hill and moved down Constitution Avenue to the boxy, marble-clad offices of the Federal Reserve Board. Bankers and traders parse every word of the Federal Open Market Committee minutes looking for signs of the speed and size of the taper, how unemployment figures may affect the pace and how quickly these Fed signals and economic data will translate into higher interest rates. The second obsession of Fed watchers is forward guidance about the eventual timing of the first fed funds rate hikes. The famous greens and blues, the Eurodollar contracts that seek to predict overnight rates two and three years ahead, fell by 100 basis points in 2013, reflecting traders’ expectations of better U.S. growth and a more aggressive tightening schedule by the Fed. These forward rates will continue to gyrate as Fedspeak and economic data shift market expectations.
Longer-term rates are also fluctuating sharply in response to incoming data, with yields on the U.S. ten-year note dropping almost 20 basis points, to 2.8 percent, in reaction to an unexpectedly low nonfarm payroll number on January 10. Yet our forward-looking poll assigns average odds of 38 percent that the ten-year Treasury yield will rise to between 3 percent and 3.5 percent, and 33 percent that it will climb to 3.5 percent or 4.0 percent. Our traders discount the risk that higher rates will prick an equity bubble. The poll’s average bet is 63 percent that the Dow will close the year above 18,500 (see also “It’s Up, Up and Away for Treasury Bond Yields in 2014”).
There are still three tail risks that could shatter those benign expectations.
Notwithstanding the Ryan-Murray compromise, a debt ceiling battle can’t be ruled out, even though most traders believe the risks of that are very low. There have been 17 government shutdowns since 1977, including the latest episode in October, and the debt ceiling has been raised 91 times since 1917, so there should be plenty of potential for mischief. Still, says veteran Republican strategist Edward Rollins, “even though folks on both sides of the political aisle are not happy with the [Ryan-Murray] deal, it is doubtful it will be altered. No one at this time wants further conflicts over the budget or future government shutdowns, and certainly most members just want to get reelected in 2014 and see what happens in the Senate races.”
Another tail risk is the collapse of Obamacare — not because the government health care website stays cranky but because not enough healthy young people sign up for the various programs. An age-unbalanced insured pool will not be profitable for insurance carriers, and the carriers cannot be forced to underwrite persistently unprofitable health care plans.
“The reality is, major adjustments will be needed to make this plan solvent, and the votes aren’t there to make those adjustments,” observes Rollins, who was famous for his skill in accurately counting congressional noses when he served in the Reagan White House. “And for the foreseeable future, the plan can’t be repealed because there are not sufficient votes to override a certain presidential veto. The long-term prospect for Obamacare is a financial train wreck than will not lower health care costs for insurance companies, hospitals or patients.”
The final tail risk is tactical: that markets misunderstand the communications from the new Yellen Fed on QE tapering or forward guidance on interest rates. Most central bankers get challenged by markets at some point early in their tenure. Eventually, both sides figure each other out, but there can be some ugly volatility in the short run. “Stanley has had some serious experience in this line of work,” a former Fed official told me in Washington, referring to Stanley Fischer, the nominee to serve as Yellen’s vice chair, who as head of the Bank of Israel presided over that country’s currency crisis in 2008. “If Janet needs any more gravitas, which I doubt, Fischer can lend her some.”
In addition to these U.S.-specific risks, there are three related sources of systemic risk that could affect the U.S. rate outlook, as well as the five other key economic issues that traders are gambling on.
The first risk is the ability of central banks to execute what one economist called “differential tapering.” Led by the Fed, central banks in developed markets doubled their assets to 25 percent of GDP in 2013 from 12.5 percent in 2008. This massive expansion of liquidity has had profound effects on virtually all asset prices and foreign exchange rates. The end of this long chapter in monetary policy experimentation is now at hand with the commencement of the Fed tapering of its quantitative easing (QE) program. The process of returning to normalized free-market conditions and the consequences for global rates, asset prices and forex relationships are unpredictable. In a world of low interest rates and low differentials between countries, differences in monetary policies and rate structures can have a very big impact on asset values and currency rates.
This normalization and differential tapering may not go smoothly. “Forward guidance and QE have reduced uncertainty and volatility for now, but it actually makes the market less stable in the long term,” argues Michael Hintze, founder, CEO and senior investment officer of CQS, the London-based hedge fund firm. “Central bankers have driven the market into the same trade. The bell-shaped probability distribution curve has been squashed from the sides and elongated upwards. The unintended consequence will be at some point to normalize the probability distribution curve, which might flatten too much and broaden the tail. Shifts moving from one market equilibrium state to another can be difficult and abrupt.”
The second systemic risk is that this unwinding of QE and the commensurate repricing of asset prices must flow through financial markets in which liquidity conditions have been deteriorating. The market-making platforms of the large banks, which historically provided the liquidity buffers for the system, have experienced significant retrenchment and shrinkage because of regulation and poor profitability. There are signs of impaired liquidity in several financial markets, which the U.S. Treasury’s Office of Financial Research catalogued in its September 2013 survey on “Asset Management and Financial Stability.” According to Oliver Randall, an assistant professor of finance at Emory University’s Goizueta Business School, in 2007 dealers held roughly 4 percent of outstanding U.S. corporate bonds for market-making purposes; those dealer inventories plunged to a little over 0.5 percent of the market in 2012. Despite the intention of the regulators to mitigate systemic risk, it is unclear just how fragile or robust the international financial system remains.
Overall volatility has eased, but no one knows when sharp, discontinuous reversions to risk-on/risk-off behavior could roil markets. “I cannot see anything presently blowing up the markets,” cautions CQS’s Hintze. “I sense no one else can see it either, and that in itself is a potential danger.”
Finally, the deleveraging process that began the financial crisis in 2008 has been stalled in some markets, particularly Europe. And China has experienced massive, potentially unstable credit expansion since 2010, an issue that worries global macro traders very much. In the U.S., for example, the ratio of private sector debt to GDP wound down from 310 percent of GDP in 2008 to 255 percent by mid-2013, according to Thomson Reuters Datastream. In contrast, the ratio of private sector debt to GDP in the euro zone peaked at 430 percent in 2010 and has slid sideways since then, as a host of policies resisted bank shrinkage and asset repricing to market-clearing levels.
“The amount of deleveraging by the private sector in the euro zone is negligible,” says an economist at a London-based asset manager. “Meanwhile, the increase in public-sector-debt-to-GDP ratios in the euro area has been steep, and despite the widespread implementation of austerity policies, these ratios continue to rise for the euro area as a whole.” Countries in which the banks and governments have resisted deleveraging are the most vulnerable to instability when interest rates bounce back to higher levels.
James Shinn (jshinn@princeton.edu) is lecturer at Princeton University’s School of Engineering and Applied Science and CEO of Teneo Intelligence. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of defense for Asia at the Pentagon. He serves on the advisory boards of Oxford Analytica; Kensho; and CQS, a London-based hedge fund.
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