Sunday, January 3, 2016
Global macro surprises for 2016 - The Fed and risk aversion
The dollar declines - The consensus is that the Fed is tightening and raising rates while the rest of the world is easing. This is all true, but if the Fed does not follow its path of increases, a dollar reversal will be the trade in foreign exchange. Is this dollar decline likely? The Fed has generally predicted a faster increase in rates over the last few years only to go slower than expected. History tells us four Fed increases per the SEP dot forecasts is aggressive.
A rate decline - With negative rates in the EU and the Fed expected to raise rates four times in 2016, the market bias is toward higher rates. This view is reinforced by the forecast that inflation will be higher and growth with continue at above 2%. Inflation is dependent on a labor market that will see real wages increase and growth that rebounds in 2016. Both are expected, but it would be unusual to see these twin forecast realized even though we are at 5% unemployment. There is still labor market slack with low participation rates.
A deflation shock - Whether called secular stagnation, a balance sheet recession, or a continued zero bound problem, there is little to suggest that inflation will touch the 2% level. While continued momentum with an oil shock is less likely, there are limited places in the economy which show upside price pressure.
The risk-off trade - The last few years have been the focus of a search or reach for yield. This has burned investors who increased exposure in small cap stock or who bought junk bonds and moved to riskier credits. Cash levels have increased in spite of low rates. Given the level of uncertainty and lack of market confidence, the risk-off trade may be the surprise in portfolio construction.
A geopolitical shock - Whether immigration, the Middle East, or the South China Sea, the markets did not react to events in 2015, but still face significant geopolitical risks. The new year eruptions associated with the executions in Saudi Arabia can easily turn into a much bigger problem for the region and the globe.