What Keeps BofA Up At Night?

The onslaught of 2012-Outlooks continues to unmercilessly suggest bullish biases in most risk assets, particularly higher quality equities and credit, and while almost as ubiquitously noting the binary nature of outcomes in the medium-term and significant downside potential. Most of the upside/downside biases reflect heavily on Europe's outcome which in turn seems to have the majority forecasting recessionary contraction being 'stabilized' by a round of quantitative easing by the ECB. BofA's Global Asset Allocation group notes, however, as the Fed has recently discovered, QE alone may be enough to stabilize a situation but a credible plan for growth is harder to achieve. Furthermore, in a topsy-turvy potentially chaotic manner, they point out that the market's expectation of QE has been enough to calm waters (or more aptly levitate markets) leaving policy makers with little choice now for fear of the instability created by not delivering what Mr.Market (as we have been noting for weeks - pressure for a 'crash' from the likes of Deutsche Bank) demands or expects. But away from European disunity, if that is possible, BofA's key global risks include a worse-than-feared-EU-recession, Mid-East unrest, US fiscal tightening, and a China hard landing but given their perspective on the extreme levels of bearishness, they prefer to hedge upside risk from their correctly cautious view.


From Bank Of America's 2012 Global Asset Allocation Macro Outlook

Our economists forecast a recession in Europe in 2012...

...softened by a round of quantitative easing from the ECB

The willingness of central banks to act was shown on 30th November 2011 as six OECD central banks plus the PBoC coordinated their interventions. With the Eurozone slipping into recession and inflation poised to drop, some of the objections to QE will likely be removed. Our EU rates strategist, Ralf Preusser, believes that the ECB can introduce QE without breaking their price stability mandate if the Eurozone faces disinflation or even deflation. A round of QE from the ECB is now widely anticipated by markets, in our view. In fact, we believe that failure to deliver QE could generate so much market turmoil that policy makers could soon find themselves with little choice. But as the Fed has found in recent months, QE alone may be enough to stabilise a situation but a credible plan for growth is harder to achieve.



Key global risks include a worse than fear EU recession...


The coordinated action from central banks on 30th November 2011 highlights the global concerns over a disorderly unraveling of the EU crisis. If the stalemate persists and Europe fragments it likely means a deep recession in Europe as well as significant slowing of global growth. European banks are major investors in Asia (Table below) and a sharp contraction of liquidity would have global consequences. Even under our baseline scenario where Europe finds a solution to the sovereign crisis, the long run effect of deleveraging is significant. Fiscal austerity and the “paradox of thrift” will drag on trade and investment for some time, creating downside risk to global economic growth in coming years.



…Mid-East unrest, US fiscal tightening & China hard landing


Beyond Europe other issues may be equally damaging. The tensions in the Middle East, as well as the rise of anti-Western sentiment in Iran, are symptomatic of heightened geopolitical risks. Syria scores particularly poorly compared to other nations in the region on measures of political and economic vulnerability (Chart below).



Although Syria is of relatively minor importance to the global oil market compared to Libya, the geopolitical ramifications of a conflict in Syria are worrying. The vested interests of power players such as Turkey, Iran, Saudi Arabia or Israel could complicate matters too, increasing the risk of a proxy war in Syria. With large volumes of production at risk in countries with vested interests in Syria, a broader Syrian conflict could rattle Middle East security and global oil markets, exacerbating oil price volatility.


This leaves the global economy exposed to a damaging spike in energy prices should the situation deteriorate.


Meanwhile in the US, the polarisation of politics was clearly demonstrated by the failure of the super-committee to agree a deficit reduction plan. Our US economists expect austerity measures to kick in fully only after the presidential election.



If Congress do not extend measures due to expire this year, such as payroll tax cuts, this creates around 100bp drag on GDP in 2012. The sunsetting of other stimulus (e.g. Bush tax cuts, etc.) adds further headwinds to the 2013 outlook. Bond markets have been patient so far with the US, largely as the focus is on Europe, but the deficit issue in the US remains a key concern.


Finally, a sharp deterioration of credit quality or liquidity in China would surely rekindle fears of a hard landing.


...But there is always an upside tail risk that growth picks up


While we anticipate a slow and bumpy recovery, the extreme levels of bearishness prompt us to hedge the upside risks in our otherwise cautious view.



It appears evident that it is sentiment not data that drives markets right now...