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"The World Is Running Low On Interventionist Ammo" SocGen Warns "China Is The Dominant Black Swan"

When it comes to crisis, SocGen notes that there is an abundance of case studies; and against the backdrop of the uncertainty shock delivered by China and the subsequent market tumult, market participants have been looking to the history books for clues as to what could happen next. While individual crises create their own risks, SocGen warns, the overriding risk  is that markets are taking less comfort today from the idea that central banks may step in with further QE-style liquidity injections to save the world.

Running low on monetary policy ammunition

 Before considering the individual risk scenarios, an overriding risk is that markets are taking less comfort today from the idea that central banks may step in with further QE-style liquidity injections. We see this as a reflection of two factors.

First, the tremendous amounts of liquidity injected to date have produced less-than-spectacular economic results. This also fits the findings of academic literature suggesting diminishing returns from subsequent rounds of QE.

 

Second, central banks have clearly become more concerned about the potential risks to financial stability from indefinitely inflating asset prices, suggesting that they may be slower to step in.

This raises the important question of how policymakers would respond to new downside shocks. Fiscal expansion in the advanced economies, and not least infrastructure investment, would be our advice, but in a downside risk scenario, we fear that this tool is likely to be deployed all too slowly and central banks be further overburdened.

China is the dominant black swan

On the major risks that we see over the coming year, one positive is that we have taken Grexit off the chart. Medium-term, we still consider a Grexit a high risk scenario, but for now euro area policymakers seem content to have given the can a good kick further down the road.

China hard landing (30% probability): The recent market tumult offered a flavour of the type of market response a China hard landing might trigger. In such a scenario we would expect to see a further, and this time, sharp decline of the RMB. We defined a hard landing as a 2pp negative real growth shock to our baseline real GDP outlook. In 2015, that sets hard landing at 5%, in 2016 at 4%.

 

China’s financial integration into the global economy is low, making a replay of the 2008 crisis – that was transmitted primarily via financial channels – less likely. To our minds, such a scenario would bear a greater similarity to a “classic” EM crisis, such as the 1997 Asia crisis. However, today emerging economies account for around 40% of global GDP. This is twice the level that prevailed in 1997. The pullback in demand in emerging economies would make such a scenario the third deflationary shock of the past decade, following the 2007/08 subprime crisis and the 2011/12 euro area debt crisis.

 

New global recession (10% probability): A China hard landing or a much-deeper-thanexpected downturn in emerging economies in general, both have the possibility to trigger a global recession. How business, consumers and policymakers respond to such a shock would determine whether recession in the advance economies would follow or not. We see a 1-in-3 chance that a China hard landing would trigger global recession. Another critical assumption is that oil prices remain at the current very low level. If there were a positive oil price shock, this could also trigger a recession.

 

Advanced consumers save the energy windfall gain (25% probability): For the OECD economies, we estimate that the oil burden (price times demand divided by GDP) will decline by around 1.5pp compared to previous year averages. For energy consumers, this marks a windfall gain. Our baseline assumption is that the bulk of it will be spent. Should consumers prove more cautious, this would lower our growth outlook considerably, knocking 0.5-1.0pp off our baseline and pushing the major advanced economies back to “stall speed” levels.

 

Fed behind the dots (10% probability): When questioned about Fed policy in relation to the economic conditions in the rest of the world, Vice Chair Fischer noted that ensuring a stable US economy would be the Fed’s greatest contribution – we agree! Should the Fed keep rates too low for too long, the danger is that, once wages and inflation pick up, markets will do the job with a disorderly bear steepening of the yield curve delivering negative ramifications for financial markets globally and not least for emerging economies.

 

Brexit (45% probability): A date has yet to be set for the referendum and it is still unclear what concessions Prime Minister Cameron will obtain from his European Union partners. Striking is how little attention markets are paying to this topic. We see three possible explanations for this. First, markets believe Brexit would do no real harm. Second, markets see only a very low probability of such a scenario materialising. Third, it’s still too far away in terms of timing (the deadline is end-2017 but the UK government is hinting that it might be held next year) and too vaguely defined to focus on. In our opinion, the third explanation is the most likely. At some point, this will hit the radars and we see substantial volatility given our view that Brexit could take as much as 1pp off growth over the next decade and that the vote (as polls suggest) will be fairly close.

But on the bright side, US domestic demand dominates the white swans

 Our previous white swan of higher-than-expected price multipliers described a scenario under which the multiplier effects that translate factors, such as lower oil prices, low interest rates and FX depreciation (where present) to the real economy turn out to be higher than we discount in our baseline scenario. In a nutshell, consumers and corporates decide not only to spend all the windfall gains of lower oil prices but take the opportunity of low interest rates to increase leverage to consume and invest. In our new GEO, we have split this risk of this positive outcome into several parts:

US invest more ... and win productivity (20% probability): Investment, be it capex or residential, has generally disappointed forecasts including our own. Looking ahead, we expect a sharp pick-up in residential investment. Our forecast on capex, albeit positive, holds room for upside surprise. This would also underpin productivity gains and thus ultimately real wage growth.

 

Higher-than-expected price multipliers in Europe and Japan (15% probability): On the external front, euro and yen have failed to deliver any significant boost to export volumes. Accommodative credit conditions have yet to deliver a major boost to domestic demand. Finally, while lower oil prices have been a positive, the multiplier effect on consumption and investment remains lower than many had hoped. Should multipliers prove stronger then expected this could deliver upside surprise, notably to our still-below-consensus euro area growth forecast but also offers some potential upside to our above-consensus outlook for Japan.

 

Fast track reform (10% probability): At the risk of sounding like a broken record, we once again highlight the need for structural reform. We are in the good company of central bankers in making this call. Nonetheless, the probability of it actually materialising remains disappointingly low, all the more so given a busy electoral agenda ahead.

Source: Societe Generale Cross-Asset Research