There are a lot of things you can say about Heisenberg, but one thing you can’t say is that I fell asleep at the wheel when it came to warning you about the risks markets face in 2017. In fact, I rarely fall asleep at all, much less while driving.
Over the past several months I’ve documented the laundry list of potential potholes we face as we careen into the new year (to continue with the car metaphor), seemingly fearless behind our equally fearless new Supreme Leader, Donald Trump.
Somehow, the idea that fiscal stimulus can prolong the equity rally and squeeze the last few drops of momentum out of an economic expansion that’s already something like 18 months overdue for a U-turn (if history is any guide) seems to trump the following set of risk factors: 1) The whole of Europe could end up looking a lot like Berlin ca. 1934 should populist candidates in France, the Netherlands, and yes, Germany manage to pull off the “impossible” at the polls, 2) China could simply fold under the pressure of trying to i) transition the smokestack economy towards a consumption and services-led model while simultaneously preserving the absurd notion that growth is still somewhere near 6.5%, ii) manage a currency devaluation intended to help boost said growth, iii) control capital outflows, and iv) curb speculation and prevent bubbles from forming in stocks, bonds, and real estate.
Thankfully, not everyone on Wall Street is willfully (and blissfully) ignorant. Here are some great excerpts from a new Deutsche Bank note which outlines two main “risk scenarios”:
Dollar appreciation and yield upturn raise the possibility of reduction in global liquidity and the unwinding of consensus trades with a time lag (as seen in the risk-off activity during Jan-Feb 2016). Our team expects risk-off activities in the first half of 2017 (relatively early). We see various catalysts, including capital outflow from China, increased uncertainty about policies in a Trump administration, US corporate earnings (announced in mid-to-late January), Italy’s bank sector, national elections in Germany, France, and the Netherlands, violations of OPEC’s output restrictions, and geopolitical risks. The dollar appreciation and yield upturn tend to lead risk-off sentiment, and the market is more inclined to react to negative catalysts.
We believe the US long-term yield upswing might overshoot around mid-year if risk-off activity (described in risk scenario (1)) does not curtail yield upswing. If the US 10y yield moves sharply higher (to 3.6% in 2Q) as forecast by our rates research team, we expect increased selling pressure on the US Treasuries by the US banks (unrealized losses in bond portfolios lower the CET1 ratio), agency REITs, and other funds (which hold large amounts of mortgage-backed securities), Japanese financial institutions (which need to conduct loss-cutting bond sales), and the PBOC (which continues to sell US Treasuries as currency intervention). Leverage regulations, electronic trading, and other factors are reducing liquidity in bond markets. We are focusing on possible overshooting too. Many investment managers lack experience in markets with unleashed upswing in the long-term yield, and this environment might trigger panic selling of government bonds and mortgage bonds.
Good points, all.