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Yves Kuhn

In October the IMF's downgrade of expectations for global economic growth, with its forecast for the year ahead reduced to 3.3%, led to a 10% equity sell-off. Weak manufacturing data in Germany, Europe's economic powerhouse, led to concerns about a widespread European recession. However, subsequently, we have seen what was probably one of the fastest recoveries. The wall of worries includes a recent tumble in oil prices. Initially there were questions as to whether the severe drop was demand-led and not driven by excessive supplies. However, since the OPEC meeting, the capital market has concluded that the rout in crude prices was more supply-driven, as OPEC continues to ignore low prices. Equity markets continued to reach new highs in the US, despite the fact that some large market caps in the energy sector lost 10-15% of their valuation. The oil rout did not stop there. As oil-producing emerging markets started to feel the heat, especially Russia, which was already on its knees, looking feverishly for a means to limit the damage to its economy. Mexico, another oil-producing country, decided to prop up the peso when its drop in valuation against the USD became too excessive.

Lower oil prices are inflationary in the mid-term, as consumers are left with more cash in their pockets. Clearly most cash-strapped Western economies must welcome this Christmas present, and after some initial panic attacks, the market has resumed breathing normally, with risk assets continuing their ascent. We note that not all risk classes reacted positively; especially high yield bonds in the US, which did not fully recover from their sell-off. Energy companies represent over 17% of the US high yield index, and their prospects seem to be gloomier with declining oil prices.

Yves Kuhn

Yves Kuhn

So what would it take to derail this red hot bull market and strike fear into investors' hearts? There are no limits to what could happen. Russia could default on some of its debt in two years, the Ukraine could collapse, China could fail to recover from its fall in property prices, and so forth. However, one of the most powerful potential outcomes would be if Europe's voters started to back away from the European project. This might not be too far off, as Greek snap elections bring closer the possibility of an EU country exiting the Euro zone. One must also not forget the far right in France and in Spain, which seem to have majority support.

The uncertainty linked to a disorderly exit by an EU country would be more powerful and more wealth destructive than any war in the Ukraine or in the Middle East. So far, the powerful wall of money provided by the various central banks has side-lined the wall of worries. However, if the market is caught out by rising uncertainty about the Eurozone's future, even loose monetary policy will not sustain investor interest in risky assets and investors will vote with their feet. If a newly-elected Greek government led by Syriza declares its intention to renegotiate Greece's sovereign debt, the resulting fears for the Eurozone future would be extremely wealth-destructive.

On the flip side, there is a positive outlook to be found. Europe's economic growth could surprise on the upside; a 12% correction in the Euro, a 40% correction in crude and the European Central Bank pumping money at an increasingly high speed into European economies could jump-start economic activity. Some estimates predict that over USD 500 bn would be returned to Western consumers through a 40% drop in crude. In fact, one of the best ways to maintain voter support for the European project is job and wealth creation. Many of the larger economies, particularly France and Spain have recognised that the voters' pain threshold has been exceeded. Luckily the German government's austerity demands are much less rigid these days.

Our client portfolios continue to see a positive bias towards risk assets such as equities and high yield bonds in Europe. In the short term, the recent oil correction will be extremely deflationary and we are braced for lower global inflation figures, both in European economies and in many emerging markets. Long-duration bonds, especially in the US, might be an interesting short-term trade. It is probably a sign of the times that even in China inflation surprises on the downside, with a 1.4% increase year on year. That said, we will look to reduce our exposure to risk assets if any of the fears over the Eurozone's future reignite and become more substantial.

By Yves Kuhn, Chief Investment Officer at Banque Internationale à Luxembourg

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