Carr's Call: The risks that matter in 2013

It’s that time of the year when everyone takes a look at 2013 and has a stab at where they think the key risks lie.

Chronic fiscal imbalances seem to loom large this year again, as they have for some years, and the World Economic Forum (in a survey of 1,000 experts) still nominates this as one of the two key economic risks for 2013. Severe income disparity is the second key risk. ‘Chronic fiscal imbalances’ doesn’t quite capture the market’s obsession with fiscal adjustment though. Fleshing it out a little more, you could break it down into generalised fiscal sustainability and austerity, with a ‘Grexit’ (Greek Eurozone exit) a particular concern. Recall Citi bank famously suggested this was a 90% probability.

The whole European project was in turn thought to be at risk, and both Spain and Italy were regarded as insolvent. Tied in closely with this was a concerning circularity. Weak sovereign balance sheets, it was thought, would accentuate bank funding pressure (leading to greater balance sheet pressures). This would then spark another liquidity crisis, which in turn would pressure the sovereign again – and so on.  There were other risks cited, for sure. Deleveraging was regarded as widespread and another threat to growth, while the US was at constant risk of a double dip – brought about by deleveraging, consumer and business caution, financial contagion and the fiscal cliff. Added to that were persistent fears of a hard Chinese landing.

Obviously none of these eventuated, not even the 90% probability of a Grexit. Indeed many high-profile economists attributed 50% plus probability of a US double dip! Again, not even close.

Now, I highlight all of this to make a very important point. There is a marked difference between what is perceived as risk and what are, in my opinion, the real risks. This isn’t to say that all perceived risks are false. It’s just that the probabilities that are assigned to them were/are completely over the top. So for instance, there was never a 90% probability of a Grexit; legal obstacles and a lack of political will always made this implausible.

Looking into 2013, I don’t doubt that the perceived risks (in one form or another) will again dominate media and market attention. Nevertheless, I think readers should instead keep their eyes on the real risks – well, what I consider to be the real risks. It is these risks, ultimately, that will destroy your wealth.

Mostly, the ‘real’ risks stem from the abuse of monetary policy by the major economies. Think of what we face – huge amounts of excess liquidity, ultra-low rates that distort investment decisions and the allocation of resources more generally – priming the hunt for yield. This has the potential to provide massive market distortions either way – up or down. Huge and unexpected swings across most asset classes:

1. Think commodity price volatility, with strong risks of a renewed surge. The way I see it, this is the largest true risk. All the planets are aligned for strong growth here, with little in the way of real headwinds. You can see the sensitivity the major economies have to it via the sabre rattling that occurs when crude approaches $100.
2. Closely related to this is the high risk of an inflation surge – no one is talking about hyperinflation or any such thing – so don’t be misled. The problem instead will be inflation rates that exceed interest paid on debt. This is already occurring in most jurisdictions where inflation is already near, at, or above target. This is the US, UK and Europe, in particular. Inflation destroys savings – a wealth tax effectively or a simple loss of purchasing power. Bear in mind also, that flawed policy responses to inflation had a major role to play in all recessions in the modern era – including the GFC. (A spike in interest rates had been behind the first round of the US housing crisis).
3. An escalation in the currency wars will only serve to exacerbate the above – again a very high risk. Already the Bank of Japan has said it will continue to print money until inflation rises to 2%. How long until the Bank of Korea, Peoples Bank of China and others respond?

These are the most likely risks emanating from what will probably be a continuation of quantitative easing (around the globe) in 2013. On the flipside, we need to consider the very real risk of QE halting this year. Already there is some noise out of the Fed to that effect. This, once again, could cause havoc –as it did in 2011 when there was talk the Fed may not engage QE further. It helped see the S&P 500 down about 10% -- and that was only on rumour. In the event, we would likely see:

1. A bursting of the bond bubble – make no mistake this will be destabilising. Yields could skyrocket.
2. Equities around the globe could tank.
3. We would likely see a sharp and destabilising $US appreciation (domestically, inflation would likely surge).
4. We would probably see a speculatively driven commodity rout.
5. And, of course, a rise in global risk premia (i.e., the cost of money).

Don’t forget there are the very real geopolitical risks. E.g., war with Iran, which some view as a very high probability. And a side war with North Korea – as well as civil unrest and, of course, the ongoing threat of natural disasters.

Now most of the perceived risks were listed above – they remain unchanged going into 2013, and as much as I ‘d love to say we’d seen the back of them, and I think the European crisis is largely over, we simply can’t say it with 100% confidence. The perceived risks remain. How could they flare up again? Well, Italian elections are to be held in late February. Recall that it was Greek electoral uncertainty that sparked a market correction last year. German elections are due in September. Similarly, a ‘Grexit’ may make a comeback if we see the current (and fragile) Greek coalition collapse, or a pick-up in civil unrest etc.

Then, of course, the US debt ceiling and the fiscal cliff (deficit reduction) is still present, and while the market is ignoring this now, history has shown it wouldn’t take much for that to change, notwithstanding the fact that little true damage will be done.

More generally we still have fears over deleveraging – consumer and financial sector. A China hard landing or other emerging market hard landing could easily remerge given we have talked about it every year for the last four years, and there are, of course, the ‘unknowns’? The list is endless, and the market embraces fear very easily.

Be mindful, but not fearful, of the risks in 2013. Even the real risks are not a base case and are unlikely this year, although they are highly likely at some point over the next few years. They will become the base case eventually for me, just not yet. The real risks should be taken seriously then, but no investment assessment can truly be made until we see the nature of the flare-up. For now, it’s probably sufficient to keep away from government bonds and be underweight in cash. As to the perceived risks? As mentioned, any flare-up here (noting that markets appear to have become more resilient to each flare-up) is usually a signal to buy risk. At this point, I doubt that will change much through 2013.