Ten Surprises for 2014 coming
I have been sitting on my ten surprises for this year because not enough ideas had crystallized… until now. I think I will be ready to write the piece next week. Let me go through my thinking somewhat stream of consciously here. As a reminder, what I am trying to do is replicate what Byron Wien has done in making ten predictions that have a 50% likelihood of panning out, but which the market assigns something like 1/3 odds. These aren’t outliers like Saxo Bank’s list. Rather they are known risks that are being underplayed.
One risk for example that I believe could be interesting is the bond bull case. The case is predicated on a stronger economy that is sustained during QE withdrawal. The thinking is the US bull case I laid out yesterday in the post on inventory builds. There are a lot of people piled into this trade or the QE liquidity trade that sees rates rising because of the missing demand from the Fed. Never mind the fact that rates have increased every time the Fed has done QE. If the economy does not turn, then we will see the yield curve flatten and the long in come down. I now believe this is a 50% scenario and the market sees it at 33% or less. So this will certainly be one pick.
Another pick may be recession in Brazil. I have been thinking about this for a while now because, as I put it Monday, “My biggest concern is Brazil because of the combustible mix of a large economy, poor governance, social fraying, rising inflation, rising interest rates, a slowing economy and a declining currency. I believe adding Brazil to China as a cause of emerging markets stress would be catastropic for sentiment and cause serious contagion. Thus, Brazil is the country I am watching right now.”
And here’s the added mix. Gene Frieda, who works at the hedge fund Moore Capital just put out a piece saying “Chances are high of exodus from EM” which lays out a good case for thinking the EM crisis will escalate. His argument is this: QE portfolio shifts caused a rush of capital into EM and that EM left policy rates too low – at negative real rates, to prevent currency rises. This caused credit excess. Now that QE is being unwound and flows have moved the other way somewhat, EM real rates have risen to prevent currency depreciation. “Only after real interest rates normalise will it be clear how much boom-time credit turns into bad debt.” And foreign exposure to EM local currency debt will create a liquidity mismatch which will cause a sudden reversal of flows. Frieda says “non-resident holdings of local currency emerging market debt surpassed $2.5tn in 2013, up from $637bn in 2008”.
I think it’s an interesting thesis and worth reading in full. It goes in line with what I wrote last week about Brazil and India. “The central banks in those two countries could hike rates to make their currencies more attractive but doing so would stress corporate balance sheets where domestic corporate debt is high. That would precipitate cuts in staff and capital investment and slow credit growth, precipitating a serious real economy slowdown. These are major economies, and the real economy effect would be felt elsewhere. The corporate balance sheet stress could trigger a crisis.” DMs don’t care about tiny Argentina or South Africa. They do care about Brazil, Russia, India, and China. So those economies are more important in terms of passing contagion. Frieda’s thesis has to be watched in those countries in particular.
What else do I have on store? Since I am upbeat like everyone else, it’s harder to make contrarian positions. The non-consensus view this year is going to have to be down. So despite my view that the risk in the US is to the upside, I may go with a downbeat surprise on the US because that is out of consensus. Let’s see.
On Europe, a recession and house price declines in France are something that’s out of consensus to think about. But what about upside surprises in Spain, Portugal or Greece. I see foreigners buying back into Portuguese property markets now. And Spain and Greece are growing again. Why not consider an upside surprise there to contrast with what’s happening in France? The key ingredient will be the European Court and OMT. I expect a favorable ruling that will mean business as usual. But an unfavorable ruling would change everything – and not just in Europe.
In EM, I think Argentina is a political mess and think hyperinflation might make the surprise list. Here, everyone is bearish. So I wouldn’t be out of step. Bur the hyperinflation view is even more bearish and that would meet the criteria.
A blowup in Auto ABS or high yield are also choices I think may be worth putting on the list because default rates are now declining. At least in Auto ABS, we can see the inventory rising, a harbinger of distress perhaps. And so I think that’s going to be a good pick.
I am downbeat on Japan. So an outlier view on bonds, equities or GDP growth might be good. If Japan underperforms, the question then is how will the markets perform and which market is least well positioned for that eventuality? Could it be JGBs rallying that is most unexpected? That’s something I am thinking about.
Going through the list mentally now, it’s clear that everyone is upbeat on economies and equities. Downbeat on bonds and skittish about emerging markets. For my surprise list to work, I will have to work from that base. This makes the job much harder because I am really more in consensus right now – and that’s a bit disconcerting. If any of you have some thoughts, pass me a note at [email protected] before I make the list next week.
That’s what’s on my mind right now. More to come next week
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