While not quite a "jarring" as the Saxo Bank "outrageous predictions", Bank of America has also put together yet another list of "other" risks for 2012, which as BofA's Martin Mauro says, "have persisted or become worse over the course of the year, but have escaped market attention due to the spotlight on Europe." The risks are as follows: i) Hard landing in China; ii) Currency wars (competitive currency devaluation); iii) Middle East oil supply shock and iv) Municipal default fears. The only thing we would add is that these are not really risks, as the are all developing processes in some stage of deterioration. And, as usually happens, they will likely all strike at the same time, just when the world is most vulnerable, likely minutes after Greece announces it has left the Eurozone, and the Euro is in legal and structural limbo. But luckily we have at least a few weeks to months before that happens. So here is Bank of America's predictive prowess in all its rhetorical glory.
From Bank of America
The “other” risks in 2012
As markets focus on Europe as the primary risk for the 2012 outlook, we highlight four more risks that could sneak up on investors in 2012. These risks have persisted or become worse over the course of the year, but have escaped market attention due to the spotlight on Europe. While our base case does not assume a flare-up of these risks, these could potentially be the unwelcome surprise of 2012.
Hard landing in China
Ting Lu, our China economist, expects a soft landing in China in 2012. There are two key risks that he outlines to this expectation: rapidly falling property investment under severe government restraints, and a much worse European sovereign debt crisis. The share of China in world GDP has increased over the years (Figure 1). More importantly, the contribution of China to world GDP growth has increased even more dramatically with nearly 18% of growth in 2010 coming from China (Figure 2). China’s support to world GDP becomes particularly important in years of slow growth in developed economies, as seen in 2008 and 2009 (world GDP contracted 5% while China GDP expanded 10%).
Therefore, a hard landing in China next year would have a disproportionately high impact on the already shrinking world growth expectations. Beyond the direct effect of a slowdown in China, the impact on its numerous trade partners could intensify the blow.
Currency wars (competitive currency devaluation)
Treasury Secretary Geithner warned China early in 2011 against the risks of not allowing its currency to appreciate quickly1. Demands to label China as a currency manipulator have repeatedly been voiced in the US Congress. While the Chinese yuan has appreciated gradually since late last year, the rate of appreciation has been only about 6% - a rate that Secretary Geithner expressed dissatisfaction with in his remarks. Moreover, the appreciation has stalled since mid-August and USDCNY maintained in the 6.35-6.40 range (Figure 3). Furthermore, it is quite unlikely that China would allow its currency to appreciate significantly in face of the headwinds facing its economy. In fact our FX strategists expect the yuan to stay in the 6.30-6.40 range for the next three quarters.
On the other hand, our US economists and rates strategists expect the Fed to undertake the third round of quantitative easing in summer 2012. Just like QE2 last year, QE3 is likely to invoke comment from China regarding its inflationary effects and dilution of Chinese investments in the US. Elsewhere in developed markets, the yen is at historically strong levels against the USD. Japanese authorities have expressed dissatisfaction, and intervened in recent months to weaken the currency. Further QE from ECB can also not be ruled out if the European crisis worsens significantly, although President Draghi has so far resisted such calls. Overall, the weakening global growth environment that we expect next year could very well trigger a race to competitive devaluation by major central banks in an attempt to boost their economies.
Middle East oil supply shock
The uprising in Libya earlier this year demonstrated how inelastic the demand curve in the oil markets can be in the short run. As Libya’s 1.6 mn b/d of supply was removed from the market, Brent oil prices spiked by over $20 (Figure 4).
While Libyan supply is expected to gradually start coming back to the market in 2012, the situation in the Middle East is far from stable. Protests continue in Syria, and potential involvement of Iran could deteriorate the political dynamics. Meanwhile, tensions continue between the US and Iran over the latter’s nuclear program. Iran is a much bigger supplier of oil (though of a different quality oil) than Libya (Figure 5). Our economists expect economic growth to start slowing next year on fiscal tightening and consumption pullback, and an oil supply shock in such an environment could materially worsen the outlook.
Municipal default fears
Readers will recall market concerns at the beginning of 2011 over municipal defaults. However, with the rally in Treasuries and the long duration of municipal debt, munis turned out to be the best performing asset class this year as the anticipated multiple defaults failed to materialize. We argued in the beginning of the year that municipal risk is significant, not systemic. However, as the European situation has worsened, credit spreads for municipals in the CDS market have retraced to the levels at the beginning of the year when default concerns prevailed (Figure 6). While the number of defaults stayed low, the year was marked by some high profile muni defaults, including Jefferson County, Alabama – the biggest muni default in history. We still hold our view that the risk of widespread defaults is low, but more high profile defaults could rekindle market concerns, especially in an environment of economic downturn.