The New different risks we highlighted in the previous note remain the 2 key market drivers: G7 monetary policy normalization (especially the US), and China’s business cycle and reform/rebalancing efforts. Obviously there are other themes and risks, as the US business cycle and the pace of the incipient European recovery, or the accumulation of emerging market hot spots in recent weeks. The debate around equity markets valuations in this low-rates environment is no small feat. But when we try to think about risks that could produce a severe market event, which would justify a more defensive approach, those 2 themes stand.

China is clearly in a complicated transition period, and the nature of its economy (still fairly centralized) makes the management of this multi-dimensional process a complicated and risky endeavor. At the same time, the Fed is now slowing down its monetary stimulus (tapering) but also thinking of its exit strategy. In the minutes of the last FOMC meeting ‘a few members’ planted the seed of a possible rate hike that might have to happen sooner than expected. For now markets disregard it as coming from the few hawks, but we see the reference to it as a seed.


The era of growth in the 10% zone is clearly over, and convergence to more normal rates of growth has started. Part of the reason is that the model of high investment thanks to cheap capital at the expense of households is not sustainable. The share of household income in GDP has fallen to levels not seen in any medium-income or developed country, and the trend against households had accelerated in the last decade. The high investment rates at a subsidized cost of capital tends to produce inefficient or unproductive investment, which in this case is backing a serious increase in debt from companies to the banking system as well as the shadow banking system. Thus, the government needs to manage normalization in the cost of capital while reversing the trend on the share of household income, with growth falling and competitiveness being affected by real appreciation and real wage growth. This is an impressive endeavor in a massive scale. There is no textbook on how to manage such a process. Though gradualism is most likely the recipe and the Chinese approach, reality has its own timing. Similar problems led to the Asian crisis in 1997-1998 in less controlled and smaller economies.

This problem is illustrated by the recent events in savings structures produced by the so-called shadow banking system. Many of the shadow banking structures where people have saved are insolvent, and the government seems to be trying to ease into savers the concept of default. So far local investors have not taken the hit, but have been bailed out by different arrangements between local governments, banks, etc. But there will be defaults, and the reaction of local and external markets depends on how the process is managed.

In the short-term, the potential for local credit markets noise is an important risk, though the real implications for the rest of the world are mostly through expectations as the real link between local credit markets and the global economy is not direct. The business cycle is the other important short-term risk. But on a more medium-term note, the whole reform and rebalancing process as growth converges to a lower more normal rate is a very risky process, bound to produce periods of high uncertainty given the difficulty in interpreting the reasons for growth “underperformance”, deceleration, or convergence, whichever view you choose to have or markets end up falling into.

Monetary policy

The idea of ‘tapering’ produced an almost 6% selloff in the S&P500 in May-June last year. Since then markets accepted that tapering is not tightening and is necessary. Markets expect the first rate hike around September 2015. Any change in that expectation would most likely have a significant effect in markets. Though monetary policy is not the only reason markets have done reasonably well over the last few years (equity markets are not necessarily expensive in historical terms, though it can be argued that they have and are expensive on the credit side), the increase in size of central banks balance sheets in G7 (especially the Fed, Bank of England and Bank of Japan) has been so massive, and rates are so low in historical terms, that hints of normalization can be perceived as the beginning of the end.

Though the Fed is now under ‘new management’ (not so new, anyways), it is difficult not to think that what comes out in the minutes of the FOMC meeting is carefully thought out and evaluated in terms of the signal it provides to markets. The fact that some members of the committee raised the need to think about a rate hike sooner than expected, despite being the few hawks, it is in our mind very symbolic of a possible effort to plant a seed and let it gradually adapt expectations to such possibility. Especially when looked from the perspective of what the idea of tapering did last year in June.

None of these two major themes is today a short-term threat of the magnitude they can become to be. But they are potential risks, important big picture themes that need to be monitored and evaluated constantly, not only through the policy measures or discussions, but also the high frequency data that can affect each debate or risk balance.

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