A plummeting oil price, the prospect of higher interest rates, record low bond yields, deflation in the eurozone, emerging market weakness, ongoing geo-political risks and a general election in the UK all have market commentators worried.
So, FE Trustnet asks the experts which possible outcomes in 2015 have the potential to seriously derail financial markets and cause havoc within an investor’s portfolio.
Though most of the experts mentioned don’t think these events will definitely happen, these are all potential “doomsday” events for markets they have in the back of their mind.
Russian economy goes into meltdown, creating heightened geo-political risk
The major surprise event of the 2014 was undoubtedly the huge fall in the price of oil.
As a result of over-supply issues and a lack of action from OPEC, the S&P GSCI Brent Crude Spot index fell 44 per cent last year, leaving the price of oil at just $49 a barrel. This has far reaching consequences for global markets, but one area that was particularly hard hit was Russia.
Performance of indices in 2014
Source: FE Analytics
The fortunes of the Russian economy are tightly correlated to the performance of oil and due to the huge falls, the Russian central bank took the decision to raise interest rates to 17 per cent which in turn caused the rouble to drop to record lows.
Most experts think the worst is over for Russia and that the oil price will find a higher level in the not-too-distant future. However, while Premier’s Simon Evan-Cook doesn’t give it a high probability, he says that if the oil price were to keep falling it could cause a very unfortunate domino effect.
He says that if there were to be another significant decline, it would put even greater pressure on the rouble.
“People think that it is money printing which sparks hyperinflation, but it is somewhat of a supply shock because hyperinflation springs from severe foreign currency moves as people scramble to get their hands on assets denominated in other currencies,” Evan-Cook (pictured) said.
“Should that happen, you have a very large and powerful country in a dire situation. I think it isn’t very probable, but is on the back of our minds.”
Tensions between Russia and the West have already worsened as a result of the crisis in Ukraine and the subsequent economic sanctions, but the threat to markets is all too clear to see if Russia is forced further into a dark corner.
Inflation surprises on the upside, causing a bond crash
Evan-Cook’s other concern is that inflation reappears, catching out the market.
The fall in the oil price, huge levels of debt in the system and a lack of bank lending growth have all been given as reasons why inflation will remain stubbornly low despite the huge amounts of QE from the world’s central banks.
At the last count, inflation in the UK had fallen to just 0.5 per cent, while recent flash estimates show the eurozone is now in deflation.
The fact that inflation has been so benign and that there are so many disinflationary impulses has meant many experts and investors now believe the likes of the Fed and the Bank of England will have little reason to raise interest rates, suggesting that bonds are therefore fair value.
Performance of indices in 2014
Source: FE Analytics
Government bonds rallied strongly last year, as the graph above shows, largely due to falling inflation expectations and many experts have been upping their exposure to fixed income markets as a result.
However, Evan-Cook warns that there is no guarantee that inflation will stay low as the fall in the oil price could have other consequences.
“The low oil price could have the effect whereby consumers have more money to spend and businesses have more money to hire people, which could cause higher inflation and force central banks to raise interest rates,” Evan-Cook said.
The manager says that because all assets are priced off the risk-free rate and most investors are not positioned for such an event, it can create problems for investors in both bonds and equities.
Massive surprise in European growth
While this may sound like good news for the global economy, Bryn Jones – manager of the Rathbone Ethical Bond and Rathbone Strategic Bond funds – says it would cause real problems in fixed income as it is an outcome that simply isn’t priced into the market.
Europe has been the perennial source of bad news for the global economy since the sovereign debt crisis in 2011.
However, in an attempt to bring about growth and stave off a Japanese-style debt deflation spiral, Mario Draghi – president of the ECB – recently announced plans for a full blown QE programme, following his initial policies of negative interest rates and providing cheap finance to banks.
Performance of index in 2015
Source: FE Analytics
This intervention has caused European equities to rally in 2015, while euro bond yields have fallen to very low levels. At the time of writing, German 10-year bunds yield just 0.4 per cent and Spanish, Portuguese and Italian government bond yields are also all at very low levels.
Jones’ concern is that this wave of ECB action may have come at a time when the European economy is starting to show signs of strength.
“European growth is forecast to be quite low, but if it goes bananas, the market just isn’t priced for that,” Jones said. “That is the one [scenario] that is most likely and will have the biggest impact on markets.”
“The evidence is building and it would mean the bund market would sell off, QE would finish, yields would rise, equity markets would go north and then central banks would be talking about reversing everything.”
Jones’ current strategy is to be long duration as his central thesis is that European growth remains subdued and yields on US and UK government bonds won’t move upwards anytime soon.
However, he says the possibility of a massive upside surprise in European growth is something he is worried about.
“The interesting thing to keep an eye on is the German economy. We saw a really strong IFO survey this week, a decent ZEW survey and PMIs have started to stabilise. I’m not saying it is, but is this a sign that Draghi’s 'pulling the rabbit out of the hat' trick has worked?”
“This is something we need to keep a close eye on.”
Falling commodity prices, faltering China and huge amounts of debt cause a 2008-style crisis
The final potential doomsday scenario is clearly the most bearish and it comes from FE Alpha Manager Crispin Odey.
In his most recent note to investors, the manager, who founded Odey Asset Management in 1991, warned that a recession was “lurking” and that it would cause a “great deal of damage, because it will happen despite the efforts of the central banks to thwart it”.
He therefore predicts a financial crisis akin to 2008 in the not-too distant future, which will mean equity markets will be devastated.
Performance of indices in 2008
Source: FE Analytics
“[In 2008] we had seen reckless spending and reckless borrowing, fraudulently obtained credit advances and overvalued housing,” Odey (pictured) said.
“And yet, despite the banks losing a great deal of money and house prices in the USA tanking, we hardly saw a recession in 2009. Why? Because when the Anglo-Saxon central banks lowered interest rates from 5.25 per cent to effectively zero, they put the equivalent of 30 per cent of net income into the hands of the overborrowed.”
Odey says that all central banks and politicians have done by slashing rates and buying up government bonds is to compound the huge problem of debt in the economy.
As there are now issues in commodity markets and in the Chinese economy, he thinks there is little more that the authorities can do to prevent a significant economic downturn.
“My point is that we used all our monetary firepower to avoid the first downturn in 2007-09, so we are really at a dangerous point in trying to counter the effects of a slowing China, falling commodities and emerging market incomes, and the ultimate First World effects,” he said.
“This is the heart of the message.”
He added: “If economic activity far from picks up, but falters, then there will be a painful round of debt default. We are in the first stage of this downturn. It is too early to see what will happen – a change of this magnitude means the darkness and mist is very great.”
