With Christmas and New Year cheer and optimism still bubbling away for most of us we now need to turn our attention to the major risk factors that are likely to impact upon the world economy and financial markets during 2013. While the world economy is estimated to have grown by over 3 percent in 2012 overall and has enjoyed such a remarkable escape from the paralysis affecting some of its constituents like Europe, a major issue is whether this stable growth trajectory will continue for the foreseeable future. At the end of the day the global stock market has been a secular bear market for over a decade and we are now at the juncture of ascertaining whether the bear will have its final growl in 2013 or we will enter a new market phase.
The economic fundamentals are very strong for world economic growth, thanks to a relatively soft landing for China. However, a number of world risk factors prevail that could upset the world’s economic and financial stability. The major risk factor emanates from the global bond market where yields have been driven down to historic lows on both sides of the Atlantic due to Quantitative Easing [QE] or the printing of money. This has had a knock on effect in emerging markets, through the interest rate parity mechanism and emerging economy sovereign debt yields are also historically very low, despite their high level of political risk and this may be why emerging economies outperformed the world’s average GDP growth by around 2 percent because of lower financing costs.
Global risk emanates from the northern hemisphere, in particular the EU and US but these can wreak havoc elsewhere. Europe is still a major issue in terms of world economic fortunes and 2013 will be a make or break year for them in terms of the single currency that necessitates closer banking and political union. Already, the UK is hinting of the need for a tiered system of membership to exist, which although critics describe as a ‘two speed EU’, would allow banking, monetary and political union to move forward at a faster rate. For would-be contenders on the European continent this could boost the viability of the Eurozone, whilst keeping the rationale of a strong Europe intact and expand the free trade area without leaving anybody out. This consensus has been gathering momentum in recent months and would certainly fortify the global institutional framework and contribute to a more stable world economic growth.
If Europe is unable to sort out its banking and monetary union in 2013 and if some member states were to leave the Euro then this will have severe repercussions on the world’s markets. However, markets are pricing in that this is unlikely to happen, unlike during 2011 at the height of the crisis.
In my view, the risks to the world’s economic system emanate from a lagged effect of the dangerous combination of the massive stimulus to the global economy that has occurred since the onset of the crisis with a series of massive QEs that were required to keep the banking sector afloat to avoid a second Great Depression. Although required at the time, government spending can crowd out private sector investment in the medium term and Quantity Theory of Money [if you believe in it] suggests that increases in the money supply through QE will not increase GDP growth in periods of economic recession, depression or financial repression that we now live in. It can be argued that this was exhibited in Japan’s economy during the early 2001 and beyond when the Bank of Japan was a major initiator of the QE monetary approach. Asset values fell rather than increased as predicted by QE. This is however highly debatable.
What QE and stimulus have done is to increase imbalances in the global economy which have not been helped by a commodity boom, which has distorted currencies like the Australian and Canadian dollar relative to the US dollar and increased the yield differential artificially between major developed countries, which is a major driver of disequilibrium in the world economy. When will these imbalances be corrected? This process could begin in 2013. Whether you look at ‘fast food’ indicators like the Big Mac currency valuation produced by The Economist magazine or a more detailed analysis of the spike in many countries Terms of Trade [that research shows is mean reverting] or long-run relative purchasing power parity, it often takes a crisis to start the process of adjustment back to a general equilibrium.
Where will the crisis emanate from? I believe that there will be a major movement of capital in the global bond market into equities and the real economy when finally GDP returns to its normal trajectory. Combined with a gradual easing to QE and Stimulus, this will cause a major jolt to the global bond market which could see price falls of around 25 percent with at least a 2 percent increase in yield that are the true rates that reflect current global risks. But the worse is the 0.75 quadrillion-dollar murky, unregulated derivatives market that will also be impacted by a sudden shock to the global bond market and who knows what might happen. The collapse of a major investment bank could be a trigger that sets off a global financial tsunami.
The best scenario is that the United States will continue to lurch between the hospital wards of economic recuperation throughout 2013 and we are expecting to see quite dramatic volatility in the world economy. VIX, the future uncertainty indicator is currently climbing and is certainly a key indicator to look at to gauge investors’ global risk expectations throughout 2013, and one that is prone to unexpected spikes with slow exponential decay. Another key indicator is the Baltic Dry Index [BDI] which measures freight rates for bulk cargo across 40 major shipping lanes in the world and which proxies for world trade. Despite some encouraging manufacturing statistics coming out from old dragon economy China, the BDI has remained bouncing along the bottom of the harbour since the onset of the global financial crisis.
Finally, global political dynamics has its hot spots too which may have far reaching implications for the world economy in terms of relations with major world trading partners such as China, Asia and the Middle East. These include tension throughout the Middle East between themselves and with the West and the perceived shift in the balance of economic power between China and Japan uncovering latent tensions. China has already stopped extraction of rare earth materials at the end of 2012 which will affect the semi-conductor industry in both US and Japan. A trade war could be in the cards. Who knows?
In summary, global risk factors emanating from Europe, the United States coupled with a softening of China’s economy and political tension in the Middle East and the Far East, the world will need to continue to navigate even more carefully through the treacherous economic oceans that lurk beyond the horizon like the artificially manipulated global bond market with its attachments to the quadrillion dollar derivatives market.
It has been a long bear market and major events will unfold in 2013 in the US, Europe, the Middle East and the Far East that may affect whether this bear will continue its aggressive growling. It’s a financial jungle out there. The world needs to continue to prepare for the unexpected. We may only be half way through this present crisis and the next one may already be an economic monster of our own making lurking in the global bond market.
It’s not over till the fat lady sings.