Macro Global

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Global Research
We highlight 10 key risks for 2014 and explain their investment implications Each of these risks provide a plausible challenge to the consensus We think the risks that could have the greatest impact are the least likely
While there is already a consensus about the economic and market outlook for 2014, we also need to be aware of the risks surrounding that view. We have drawn up a list of what we view as the top 10 such risks mainly developments that would be negative for the global economy and financial markets, but there are also several positives. These are not forecasts, but scenarios that we feel investors should consider as we head into the New Year.
QE uncertainty

Top 10 risks for 2014

Multi-asset special

Fed tapers without a strong recovery Fed is forced to increase QE QE leads to inflation
Emerging-market risks

10 December 2013

China hard landing EM current-account crisis

Developed-market risks

Fredrik Nerbrand Global Head of Asset Allocation HSBC Bank Plc +44 20 7991 6771 fredrik.nerbrand@hsbcib.com Stephen King Chief Economist HSBC Bank Plc +44 20 7991 6700 Daniel Fenn Strategist HSBC Bank Plc +44 20 7991 3025

Abenomics triggers financial instability US debt ceiling not raised Successful eurozone rebalancing
Good/bad price declines

The spectre of deflation Large oil price decline

stephen.king@hsbcib.com

dan.fenn@hsbcib.com

Amongst these risks, we believe that a Chinese hard landing and the Fed either expanding QE or deciding to taper without a sustainable recovery would have the biggest impact; however, we believe that a failure of Abenomics, a large decline in oil prices, or the spectre of deflation are the risks more likely to occur. Inevitably though, these assessments and our selection of risks are subjective. We may be worrying too much about some of those in our top 10 whilst ignoring other risks that, in time, may prove more important. In an uncertain world, however, the best we can do is highlight some of Donald Rumsfelds known unknowns. We cannot say anything about unknown unknowns. By definition, black swans cannot be anticipated.

View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Bank plc

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

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Executive summary
We split potential risks into four categories: QE uncertainty,

EM risks, DM risks, Good/bad price declines

We consider each risk in turn and discuss possible investment

implications if it were to materialise

Broadly speaking, risks associated with a severe cyclical

downturn would have the biggest impact, but are the least likely

In any investment process, it is critical to consider those risks that may not be part of ones central outlook, but nonetheless remain real concerns that could potentially have major investment implications. How many, after all, thought enough about the dangers of a sub-prime meltdown in 2008, or the sudden deflation of the dot.com bubble in 2000? How many thought that quantitative easing was bound to end in inflationary tears when, to date, inflation in many countries has been too low, not too high? How many put all their eggs in an emerging-market basket only to discover over the last 12 months that earlier excessive hot money inflows had, in too many cases, led to widening balance of payments deficits and severe growth slowdowns? With this in mind, we have selected 10 key risks that we believe could potentially have a significant market impact over the next 12 months. We focus only on those risks that might possibly occur in 2014. That means that we have excluded risks that are of concern further out, such as a referendum on UK membership of the EU, or secular long-term risks associated with debt sustainability. Similarly, we have excluded risks that would have an enormous market impact but have a negligible

probability of occurring in 2014 (such as a major country defaulting on its debt). In Chart 1 we show our assessment of the probability of each of these events and their likely market impact if they were to occur. In general, we expect that the more probable events will have a smaller market impact than the less likely events. Importantly, there are linkages between these risks, and hence we have grouped them into four categories. QE uncertainty remains a key risk for 2014. Will macro-prudential concerns cause the Fed to taper even in the absence of a robust recovery? Or could it expand QE because of renewed economic weakness? Could QE actually lead to inflation? Emerging-market risks also persist. A severe cyclical downturn would increase the probability of a Chinese hard landing and the risk of further stresses in EM countries with large current-account deficits. In developed markets, a successful eurozone rebalancing would have positive consequences; but US debt-ceiling negotiations and Abenomics remain concerns. Finally, the spectre of deflation and a large decline in oil prices are linked, but clearly good/bad price declines have very different investment implications.

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1. Global risks landscape 2014e

Higher

Fed is forced to increase QE China hard landing Fed tapers without strong recovery EM current-account crisis Abenomics triggers financial instability

Market impact

US debt ceiling not raised

QE leads to inflation

The spectre of deflation Successful EZ rebalancing Large oil price decline

Low
Low QE uncertainty

Probability EM risks DM risks Good/bad price declines

Higher

Note: The chart should not be read as the middle of the x-axis representing 50%. Rather, it highlights the relative probability of the different events. Source: HSBC

Summary table of different risk scenarios Summary QE uncertainty Fed tapers without a strong recovery Fed is forced to increase QE QE leads to inflation EM risks China hard landing Macro prudential concerns or overly-optimistic forecasts cause the Fed to act before a recovery is fully developed. Cyclical data surprises on the downside and the Fed expands asset purchases in response. The recent years monetary policy has a lagged effect on price stability as output gaps may have closed more than previously believed. As Chinese policy makers try to shift towards the quality rather than the quantity of growth, cracks appear in the shadow banking system and overall credit environment. A sudden inability to finance a large current-account deficit, either because of a change in financial conditions elsewhere in the world or because of a sudden deterioration in domestic growth prospects. Cyclical data disappoints despite massive stimulus which would highlight that the structural problems are still present and potent. Political polarisation leads to the debt ceiling not being raised and potentially to delays in coupon payments on US Treasuries Wage growth in Germany and a reduction in its current account lead to improvements in the peripherys external-demand outlook. EZ growth prospects recover and further integration efforts are implemented. Most assets would fall in value in the initial sell off with cash the only diversifier. But as growth surprises on the downside, Treasuries rally. As growth stalls, riskier assets sell off as the success of QE is drawn into question. Treasury yields fall. Gold, metals and EM equities rally. US Treasuries sell off materially. Investment implications

The sell-off is likely to be centred on EM-dependent assets, but metals in particular, as Chinese investment growth would wane. DM markets to do relatively better as input costs fall. The fragile five currencies depreciate and EM equities fall. If the current-account crisis is driven by weak growth in these countries the fallout would be contained relative to a taper-driven crisis. JPY weakness on the back of further expectation of BoJ monetary support. Wider Asian markets do relatively well. If an actual default occurs then cash is initially your only hiding place. After the initial volatility though, Treasury yields should fall. A slow burn positive risk. General risk premiums grind lower. Periphery spreads decline but equity markets would outperform fixedincome assets due to a rotation of asset allocations. Initially, eurozone equities would sell off before recovering on the prospect of outright QE by the ECB, which would also weaken the EUR. While oil and oil-related assets fall, equities do well and bond yields decline due to lower inflationary risks.

EM current-account crisis DM risks Abenomics triggers financial instability US debt ceiling not raised Successful eurozone rebalancing

Good/bad price declines The spectre of deflation Deflation starts to materialise in DM. The greatest risk is in the eurozone due to a conservative central bank, a bank-lending dependent financial system, and an absence of an effective banking union. Large oil price decline Supply-side shock from either an increase in production in MENA, shale oil, or a normalisation of Irans relationship with the rest of the world.
Source: HSBC

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QE uncertainty
The Fed could taper too early despite a weak economic backdrop

because of macro-prudential concerns

Or it could be forced to expand QE because of renewed cyclical

weakness
There is also a risk that QE could actually lead to inflationary

pressures

Fed tapers without a strong recovery

We cannot be sure what a Janet Yellen-led Fed will look like. She may have a dovish reputation but other voting members next year most obviously Jeremy Stein, Charles Plosser and Richard Fisher have very different world views (Chart 1). To be fair, ever since the days of Paul Volcker, the Chairman has typically dominated proceedings but, with the QE debate becoming increasingly heated, it is not quite so obvious that a clear dovish consensus will emerge. Moreover, the Federal Reserve has suffered from a persistent optimism bias in recent years, too often forecasting strong recoveries that, in the end, failed to materialise. As QE1 and QE2 ended, so economic momentum faded. Might tapering lead to a similar outcome? Once again, might the Fed prove too optimistic about the economic outlook? Tapering could occur in two ways that may, eventually, undermine economic recovery. The first probably less likely is that the Federal Reserve begins to place much more emphasis on the longer-run costs of quantitative easing: Wall

Street benefiting relative to Main Street, an excessive expansion of the Feds balance sheet, distortions in financial markets that lead to a misallocation of capital and, perhaps, worries about the impact of persistent QE on global imbalances (see Measuring the cost of a QE exit, 27 May 2013). The second more likely is a straightforward forecasting error based on an overly optimistic assessment of future economic conditions. Either way, the gap between financial hope and economic reality is in danger of closing, perhaps violently through a major sell-off in risk assets. If the Fed did taper without a robust recovery it would signal that despite all the QE on offer over the years, the US recovery remains soft by past standards. In this scenario, investors would have every reason to worry. Moreover, many investors state that, while they are relaxed about the prospect of tapering, they are concerned that others are not and hence there is a risk that they will act on the assumption that others will panic.

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1. There will be a shift in the relative dovishness of FOMC voting members in 2014
DOVISH Esther George (Kansas President) HAWKISH

Voting in 2013

Eric Rosengren (Boston President) Charles Evans (Chicago President) James Bullard (St. Louis President) Ben Bernanke (Chairman)

Permanent Members

Janet Yellen (Vice Chair) Jerome Powell (Governor) Jeremy Stein (Governor) Daniel Tarullo (Governor) Sarah Raskin (Governor) William Dudley (NY President) Sandra Pianalto (Cleveland President)

Voting in 2014

Charles Plosser (Philadelphia President) Richard Fisher (Dallas President) Narayana Kocherlakota (Minneapolis President)

Not voting in 2014

Note: This chart is based on a graphic originally published by Reuters. Source: HSBC

Still voting in 2014

Investment implications
Initial general market sell off with bonds and equities both hit but equities faring worse USD cash would be the only real diversifier Bonds subsequently recover on the weak growth outlook The investment implications would be similar to the May/June 2013 sell-off. USD cash would be the only real diversifier in this scenario. A policy error from the Fed is likely to cause growth and inflationary expectations to wane; therefore Treasury yields would rise initially but then fall as markets moved to discount deteriorating growth prospects. Furthermore, a more hawkish Fed would also bring into question the Fed put so risk premiums should rise in general.

Fed is forced to increase QE

While the current economic environment looks relatively healthy in the US, it is far from booming. A key input in the Feds decisions on asset purchases is its economic forecasts, and these have tended to be overly optimistic (Chart 2). In addition, imagine a scenario in which there is another shock to aggregate demand. The key to understanding this risk is to consider the likely sequence of events that would subsequently unfold. As the business cycle moderates, the structural deficiencies in many parts of the world would become more exposed. This would then push up risk premia and would potentially amplify the risk of another recession. In this environment, the Fed could easily argue that another round of QE is warranted to stabilise financial markets, which could put us another step towards a serious discussion about strategies to monetise debt

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(although the debate about such policies is unlikely to unfold in 2014).

2. Federal Reserve growth forecasts have tended to be overly optimistic
6 5 4 3 2 1 0

QE leads to inflation
Although the debate about QE is now centred on when the US is going to taper, this wasnt always the case. Rather, the early debate focused on the impact of asset purchases on the level of central banks balance sheets. It then shifted on to the types of assets that were being purchased, before moving on again to the flow of purchases. Alongside these debates there has been much discussion, and disagreement, amongst central bankers about the channels through which QE works, how it can be made most effective, or, indeed, if it actually works at all. Despite these debates though, we still do not know exactly what the final outcome of recent monetary policy will be. One of the very early fears was that as the Fed expanded its balance sheet, asset purchases would ultimately lead to inflation. So far, these fears have proved unfounded though, and inflationary pressures have failed to materialise. This doesnt, however, mean that QE wont spark inflation in the future. The most likely trigger for this would be a more constructive view from banks that increases their propensity for lending and diminishes their appetite for government bonds and central bank reserves. Another source of lending propensity may be a function of regulatory changes. For example, the move in relative cost of capital for government bonds versus bank loans on the back of Basel III leverage ratio regulations could be a catalyst for such a shift. This effect would be compounded if the recent downward trend in labour-force participation rates proves to be more structural than cyclical (Chart 3). The decline in participation rates is in part the result of ageing populations and older generations leaving the labour market (see A cyclical downturn is nigh, The Allocator, 29 May 2013). However, if others have also left the labour force for good, this would mean that output gaps are not as large as

Q4 2008

Q1 2009

Q2 2009

Q3 2009

Q4 2009

Q1 2010

Q2 2010

Q3 2010

Q4 2010

Q1 2011

Q2 2011

Q3 2011

GDP growth estimate range (2011) Actual 2011 growth

Source: US Federal Reserve

Investment implications
US Treasury yields would grind lower Equities would fail to react to more QE Initially, we believe markets are likely to react to the deteriorating economic environment with severe selling pressure in riskier markets. A key market focus on fundamentals is likely to cause current account and budget deficit country assets to suffer disproportionately. However, US Treasuries should do relatively well as risk aversion drives assets back towards perceived safety. The key question following this initial phase is whether or not additional QE continues to drive equity markets higher. We doubt that this would happen because the effectiveness of QE to generate sustainable growth would be questioned. Weve already had the multiple expansion phase of the equity recovery, so further gains would require earnings to strengthen (see Global equities in 2014, November 2013).

Q4 2011

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currently envisioned, which could add to any future inflationary pressures.

3. Inflationary pressures will depend on how much of the decline in US labour-force participation is structural
68 67 66 65 64 63 62 93 95 97 99 01 03 05 07 09 11 13 US labour-force participation rate
Source: HSBC

68 67 66 65 64 63 62

Investment implications
Real assets such as metals and gold would rally EM equities would also rise Treasury yields would rise materially Metals, EM equity markets and gold would be the most likely beneficiaries from this scenario (see REITerate the need for an inflation hedge, The Allocator, 5 March 2013). US Treasury yields would rise materially both on the back of faster than expected tapering and rising inflation and growth prospects. Investment-grade credit is also likely to suffer as capital flows leave for greater economic beta exposure.

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Emerging-market risks
The emerging world would remain susceptible if we entered a new

period of economic weakness

A severe cyclical downturn could cause a hard landing in China and impact other emerging economies running large current-

account deficits

China hard landing

As Chinese policy makers attempt to shift towards the quality rather than the quantity of growth, challenges are likely to be encountered. In particular, bringing the shadow banking system back in check is going to be problematic. In 2009, when the export led growth story stalled (Chart 4), China managed to continue its growth path but with a stellar growth rate in credit creation. If external demand remains subdued and credit creation wanes, this could cause the growth engine overall to stall.
4. China managed to continue its growth path based on credit creation rather than exports
% 60 50 40 30 20 10 0 -10 -20 -30 Dec-04 % 60 50 40 30 20 10 0 -10 -20 -30 Dec-06 Exports
Source: HSBC, Thomson Reuters Datastream

While China still has plenty of potential for economic catch-up, it has also ended up with some weaknesses associated with potential misallocation of credit and the still-dominant role of the state-owned enterprises. The Third Plenum points to a new approach for China associated with more in the way of microeconomic reform (see Chinas turning point: Beijing sets a bold reform course, 18 November 2013) but it is just possible that the weaknesses coalesce into a story of temporary severe weakness in China with growth dropping far below the 7% threshold considered necessary to prevent rural angst.

Investment implications
Commodities prices would collapse, EM assets would sell off and AUD would come under pressure USD and Treasuries would benefit A sharp loss in growth would accelerate capital flows away from China, but also from EM more broadly, as investors seek relative momentum plays. Given the dependence on a healthy China in many EM economies (particularly for commodity producers), a slowdown in China would be a wider EM problem.

Dec-08

Dec-10

Dec-12

Domestic credit growth

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Markets would likely react to this story with a general sell-off of EM assets and metals in particular. Chinese banks may come under further selling pressure as the credit environment turns ever more problematic. Investors would rebalance their portfolios towards developed markets which would have greater relative growth momentum and benefit from lower commodity prices. They may also benefit from cheaper imports from China as wage inflation there would stall. It should be noted that this is a relative rather than absolute preference as most risks assets would fall and demand for USD and Treasuries in particular would rise.

result in higher domestic inflation and, eventually, higher interest rates. The other, more painful, option would be for these countries to close their current-account deficits by living within their means. Put another way, like southern European countries through the eurozone crisis, they might be faced with the possibility of crunching recessions.
5. Currencies of the fragile five weakened against the USD following taper talk 150 150
140 130 120 110 100 90 80 Nov-10 BRL Jun-11 Jan-12 INR Aug-12 IDR Mar-13 ZAR Oct-13 TRL 140 130 120 110 100 90 80

EM current-account crisis
While we remain optimistic about their long-term growth prospects, were fully aware that some emerging nations suffer from the occasional financial fracture. A common cause is a sudden inability to finance large current-account deficits, either because of a change in financial conditions elsewhere in the world or because of a sudden deterioration in domestic growth prospects (see Capital Flows into EM: The push and pull paradox, August 2013). Across the so-called fragile five India, Brazil, Indonesia, Turkey and South Africa both conditions would be a threat in 2014. Having benefited from the Federal Reserves earlier monetary generosity, hints of tapering earlier in 2013 left the fragile five with weaker currencies (Chart 5) and higher interest rates. At the same time, their economies were slowing down, a reflection of underinvestment in infrastructure and education over a prolonged period of time. The combination of higher funding costs, deteriorating fundamentals and already large current-account deficits left them facing financial upheaval. Its easy enough to assume these countries can grow their way out of their problems via improved competitiveness thanks to weaker currencies, but the danger is that attempts to do so will simply

Note: All series show the USD exchange rate rebased to 100 in November 2010. Source: HSBC, Thomson Reuters Datastream

Investment implications
Fragile five currencies would come under pressure Commodities, and metals in particular, would likely fall In this scenario, we would buy USD, GBP and EUR (core) sovereign bonds The investment implications for this risk are fairly similar to a Chinese hard landing. Currencies within EM that are particularly exposed to a withdrawal of liquidity would suffer the most. Here, we would highlight the fragile five currencies BRL, INR, IDR, ZAR, and TRL. In addition, metals prices are likely to fall and volatility for both equities and currencies is likely to rise significantly. A slower growth outlook would also likely support Treasuries as investors move into safe havens under the assumption that the current-account crisis is likely to increase downside risks for the more structurally vulnerable economies, such as the periphery.

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Developed-market risks
In Japan, Abes three arrows are still in flight but in 2014 the

market may decide that Abenomics has missed the target

In the US, any political discord driven by partisanship might result

in Congress not raising the debt ceiling

In the eurozone, there could be a successful rebalancing which

would result in a reduction in the German current-account surplus

Abenomics triggers financial instability

For all the talk of a Japanese economic renaissance, the economic pick-up of 2013 may be difficult to sustain into 2014 and beyond. Inflation has risen modestly but despite all of Prime Minister Shinzo Abes pressure on large Japanese companies, it is not at all obvious that wages are moving up at the same pace. If so, the danger is that Japan begins to suffer a real-wage squeeze similar to the UK experience in recent years (Chart 6). Along with a sizeable increase in VAT, this squeeze may limit the extent of any consumer recovery.
6. Could Japan suffer a real-wage squeeze like the UK?
%YoY 4 3 2 1 0 -1 -2 -3 -4 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: HSBC, Thomson Reuters Datastream

The so-called third arrow structural reform is designed to overcome these problems. For all the monetary and fiscal stimulus on offer in arrows one and two, Mr Abe knows that Japans problems are not demand-related alone. The lost decades reflect an ageing population, a lack of sufficient opportunity in the workforce for Japans women, an absence of immigration and, more generally, a reluctance to embrace necessary structural reforms. Imagine, though, that growth fades, inflation doesnt pick up sufficiently and reforms dont come through quickly enough. Would the Bank of Japan then have to offer even more aggressive monetary stimulus? Might the monetary helicopters have to be launched in a desperate shift to the monetized financing of significantly bigger budget deficits? Would international investors and Japanese households then lose faith in the JPY, leading to its collapse on the foreign exchanges triggering, perhaps, an excessive acceleration in domestic inflation? Given Japans recent history, none of this might seem terribly likely but, when political promise and economic reality dont easily gel, monetary instability is often an unfortunate by-product.

UK real wage growth (Average Weekly Earnings ex. bonuses minus CPI inflation) %YoY

4 3 2 1 0 -1 -2 -3 -4

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It is also worth noting that the secular growth story in Japan is waning. One factor in this is a much lower demographic dividend. Demographics play a key role in productivity and GDP growth; as a population ages, this acts as a drag on growth. The demographic dividend is driven both by the number of people in each age group and the productivity of these groups. As a countrys population ages, there are more people in the usually less productive older age groups. To quantify the size of this effect we calculate a marginal demographic index which measures the extent to which demographics are hindering growth (see Baby boom to ageing gloom, The Allocator, 29 April 2013 for more details). On this basis, the Japanese demographic outlook is deteriorating and is now a permanent drag on growth (Chart 7). This implies that productivity gains are needed every year just to keep GDP static.
7. Deteriorating demographics will continue to act as a drag on growth in Japan 3.0% 3.0%
2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 1950 1970 1990 2010 2030 2050 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5%

Investment implications
JPY weakness Wider Asia equity markets would benefit JGB markets should remain relatively unaffected due to supportive monetary policy Given waning Japanese economic momentum and strong domestic and foreign capital outflows, the JPY would weaken. This would make Japanese corporates more competitive and foreign sales and earnings potential in JPY terms would therefore improve. There would also be strong capital flows into the wider Asian markets so we would expect Asian equity markets to do relatively well. Bond markets would remain relatively unaffected as on-going monetary policy would support JGB prices.

US debt ceiling not raised

The US Congress eventually raised the debt ceiling in October, but there was a fair degree of political brinkmanship before a deal was finally struck. Even then, the can was only kicked a bit further down the road with the result that the debt ceiling will again need to be raised at some point during 2014. According to projections from the Congressional Budget Office, the governments extraordinary measures will be exhausted in March, but tax refunds and receipts could shift the date when funds run out a bit further into May or June (see US Budget and Debt Ceiling, 17 October 2013.The big question then is: are we again going to have the same political confrontation over the debt ceiling in 2014 that we had in 2013 (see Debt ceiling drama, 14 October 2013t is worth noting that in 2013 both negotiations about the federal budget and raising the debt ceiling occurred at roughly the same time. This does not need to happen in 2014; hence, here we focus specifically on the debt ceiling not being raised. Whilst a federal government shutdown

Japanese Marginal demographic index

Source: HSBC

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would act as a fiscal drag it would be a less significant event than a failure to raise the debt ceiling. In favour of the argument that the 2014 debt-ceiling negotiations will just be a repeat of 2013 is that, based on the voting records of US Congressmen, both chambers of Congress are more polarised now than at any time since the period of Reconstruction following the US Civil War (Chart 8).
8. US Congressional voting polarisation
1.2 1.0 0.8 0.6 0.4 0.2 1877 1897 1917 1937 1957 1977 1997 1.2 1.0 0.8 0.6 0.4 0.2 House polarisation Senate polarisation

politics trumps national politics. If, as former Speaker of the House Tip ONeill argued, all politics is local, then some members of both Houses that are up for re-election may believe that it is in their best interests to follow the views of their local constituents and to oppose raising the debt ceiling. On the flip-side though, they may decide that the interests of the national party are paramount, and thus they should vote to raise the debt ceiling. Neither party fared particularly well in opinion polls during the last set of negotiations, but the Republican Partys poll numbers fell more sharply than the Democratic Partys (Chart 9). Ultimately, there was little change in terms of policy as a result of the government shutdown and the debt-ceiling confrontation, just a deterioration in the publics perception of politicians.
9. Republican poll number fell relative to Democrats during the government shutdown and debt-ceiling negotiations 10 10
8 6 4 2 0 -2 -4 Nov-12 Feb-13 May-13 Aug-13 Nov-13 8 6 4 2 0 -2 -4
Democrat-Republican generic Congressional poll spread
Source: RealClearPolitics

Note: The chart shows a measure of polarisation in each chamber of Congress that is based on the roll call voting records of the different legislators. A high polarisation for a Congress implies that lawmakers tended to vote along party lines. See Voteview.com and Polarized America, N. M. McCarty, K. T. Poole, and H. Rosenthal (MIT Press, Cambridge, MA, 2007) for more details. Source: Voteview.com

This view that we will again see political discord in 2014 is further supported by the fact that, despite the uncertainty surrounding the debtceiling negotiations in 2013, the market impact was, in the end, minimal. Although yields on T-Bills maturing around the debt-ceiling deadline spiked briefly, the effect beyond the T-Bill market was limited. It is therefore plausible that the negotiations will again go to the brink because some politicians will argue that those stressing grave consequences should the debt-ceiling not be raised were overstating their case. The decisions on how far to push the negotiations will, of course, come down to political calculation; in particular, whether local party

Given this, lawmakers may decide that it is pointless to re-enact 2013 in 2104 because they emerged with very little but paid a political price. This therefore argues in favour of a quick resolution this time; and this view is supported by the fact that there are mid-term Congressional elections in November 2014, so both parties will presumably be keen not to alienate voters.

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Investment implications
Initially the only place to hide would be cash After initial volatility, Treasury yields would fall EM assets and equities would fall If the debt ceiling is not raised the only place to hide would initially be cash. However, the secondary impact from a drop in sentiment would support Treasuries. On OECD projections, US GDP would contract by almost 7% and inflation would drop by nearly 1.5% over one year if the debt ceiling were to bind. This slower growth outlook would have a particularly large impact on regions with high exposure to the global cycle. We would highlight that EM assets in general are likely to underperform. Investors looking for additional safe havens would no doubt gravitate towards the EUR. However, it would not be a uniform rally in eurozone assets. The weaker cyclical outlook would hurt periphery bonds while Bund yields would in all likelihood test new lows.

10. The German current account surplus has increased while deficits in the periphery have risen
EURbn, 4Qsum 200 100 0 -100 -200 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Germany Other Periphery four Current account EURbn, 4Qsum 200 100 0 -100 -200

Source: HSBC, Thomson Reuters Datastream

Successful eurozone rebalancing

Before the onset of the global financial crisis, it appeared that the eurozone made little, if any, contribution to global imbalances. That, however, ignored a key imbalance within the eurozone: the German current-account surplus was huge, as were the deficits in southern Europe (Chart 10). The eurozone crisis has primarily been a story about the disappearance of the deficits in the South (see Austerity can work: But the eurozone needs to change course, 2 December 2013). Germanys surplus, however, has remained resolutely enormous. This is one of the reasons demand in the eurozone has remained depressed and why inflation is now undershooting the ECBs assumed target.

Its just possible, however, that change might be a-foot. Recent pay settlements have been above inflation and the grand coalition in Germany will start to implement a nationwide minimum wage in 2015 which, in turn, might ratchet up German wages more broadly. That, in turn, could lead to a much needed boost for German consumption that might boost import demand. Some of that increased demand might, in turn, improve export prospects for countries in southern Europe. The resulting reduction in the German current-account surplus would thus be good for Germany and good for the eurozone more broadly. Its worth noting, however, that a lower German current-account surplus could also result from more malign influences. Most obviously, weaker demand from the emerging world which, until now, has been a mainstay of German industrial endeavour, could lead to a lower surplus as a result of weaker exports. Under those circumstances, German would fall victim to the rolling recessionary rebalancing which, to date, has mostly affected countries elsewhere in the world.

Investment implications
Slow burning positive for risk markets with particular boost to periphery equities

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EUR and peripheral bonds would do well Global equity markets would outperform bonds in theory The main problem with this risk from an investment implication point of view is that it will be difficult to spot initially that this indeed is occurring. That said, a successful rebalancing of the eurozone would be a great relief for many investors who have feared this tail event over the last few years. Consequently, European asset markets would appreciate with particular focus on Italian and Spanish assets. Government bond spreads vs. Bunds are likely to contract further and the financial sector in the periphery would rally even further. In general, this risk would put downward pressure on risk premia but also cause a rebalancing of European assets in favour of equities. This rebalancing is likely to be felt globally with equity markets greatly outperforming bonds.

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Good/bad price declines

There are risks of both good and bad price declines in 2014 In the developed world, the spectre of deflation continues to haunt

several economies
but a supply-side shock could drive oil prices lower

The spectre of deflation

Given the remarkably low level of interest rates, the generosity of central banks in expanding their balance sheets, and earlier fears that unconventional monetary policies might eventually lead to excessive inflation, it is perhaps surprising that, as 2013 draws to a close, inflation across the western developed world is coming in well below central bank targets (Chart 11). In truth, however, inflationary undershoots were always likely given the nature of the financial crisis. Many economists would argue that output in the developed world is still well below trend, pointing to a large disinflationary output gap. Meanwhile, the financial system
11. Developed market consumer price inflation has fallen
5% 4% 3% 2% 1% 0% -1% -2% -3% Dec-08 Dec-09 US Dec-10 UK Dec-11 Dec-12 5% 4% 3% 2% 1% 0% -1% -2% -3% Dec-13 Japan

is no longer as dynamic as it used to be with banks suffering lower levels of funding and higher capital requirements, limiting the creation of credit. The resulting disinflationary trends have been most obviously reflected in remarkably low wage increases on both sides of the Atlantic. Increasingly, it looks as though workers are either pricing themselves into lowerproductivity jobs (the UK) or giving up looking for work altogether (the US). Could the disinflation seen so far eventually lead to outright deflation? Japan took many years finally to succumb to deflation. In the early-1990s, as the first lost decade began, inflation in Japan was still relatively elevated. But with persistently low growth and a series of financial fissures, prices eventually started to fall. Across the western developed world, the most likely region to succumb to deflation this time around is probably the eurozone, thanks to a conservative central bank, a bank-lending dependent financial system, an absence of an effective banking union and clear indications of a persistent absence of credit growth.

Germany

Source: Thomson Reuters Datastream

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Investment implications
Initial downside risk to equities but ECB QE expectations would support equities EUR would weaken High-yield spreads widen Markets are likely to respond to this risk by de-rating equities and driving bond yields to ever lower levels. This would be of particular importance in the eurozone where deflationary risks are arguably the highest. However, the prospect of ECB outright QE would offset the initial equity downside in the same manner that BoJ action has lifted Japanese equities. The extent of the growth decline would determine periphery bond returns. On balance, we believe the risk/reward would favour equities over periphery debt due to the worsening debt-to-GDP ratio outlook in the periphery. In credit, investment-grade spreads would tighten while high-yield spreads would widen on the back of a much slower growth outlook and less direct policy support.

day to global supply. Furthermore, a normalisation in the relationship between the EU/US and Iran would increase the expectation of supply increases although those additional supplies would be unlikely to appear in 2014. Our oil team believes a ramp-up from Iraq is also possible, with up to about 0.5 million of Kurdish exports potentially available. There is thus, perhaps, around 2 million additional barrels per day of supply available in 2014, which is significantly greater than the forecast increase in demand of 1.2 million barrels per day (see Crude market outlook: Updating our oil price assumptions, 6 December 2013). The main question in this scenario is the OPEC reaction function and particularly how much GCC production plans would be altered. If, as in 2008, OPEC countries delay cutting production, then oil prices could drop below USD90/bbl. In addition, non-OPEC production is expected to rise over the next few years. In particular the shale driven increase in oil production in the US is significant (see Shale oil and gas: US revolution, global evolution, September 2013).
12. US crude production, mbd
8 7 6 5 4 Nov-03

Large oil-price declines

In order to push oil prices below USD90/bbl there are two obvious factors: demand and supply. Since a demand-driven decline in oil prices is likely to coincide with a shift in perceptions around global-growth prospects, perhaps precipitated by a China hard landing or central bank action, we focus our attention on the supply driven side of the story in this risk. So what is the most likely route to achieve a supply driven price decline? A return of Libyan production to the tune of around 1 million barrels per day is not impossible. Strikes at the export hubs are the main source of constraint rather than the production side as most of those facilities are largely intact. In addition, an end to hostilities in Syria could add another 400,000 barrels of oil per

Nov-05

Nov-07

Nov-09

Nov-11

Source: EIA, Bloomberg

But this is not solely a US story; other parts of the world are also increasing their shale production plans (Chart 13). This type of supply driven oil price decline would be a potent energy boost for the global economy. Most notably, this

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is likely to support developed-market growth. As such, global growth would improve, but during a period of downside risks to overall inflation levels.
13. Global oil supply increases is not solely a US story
USA Brazil OPEC NGLs Biofuels Canada Other FSU Africa Process gains Colombia Europe Russia Source: IEA estimates, HSBC

0.5

1.0

1.5

2.0

Investment implications
Equities and bonds would rally Sell oil and oil dependent assets Direct investment implications for this scenario are quite straight forward: oil and oil dependent assets would come under pressure. However, the aggregate impact is probably positive as it would act as a boost to economic activity around the world. As such, we believe aggregate equity markets would do relatively well. Bond markets would probably also respond relatively positively as inflationary risks would be muted. Gold and REITs would be the most likely laggards.

While this sharp deflation of oil prices would be good news for the world's oil consumers, it would also have meaningful negative consequences for its oil producers, with the heavily energy dependent Middle Eastern states particularly at risk. A drop to USD90/bbl would push most from surplus into deficit and threaten to disrupt growth and potentially even the political stability of the region. For the pivotal state of Saudi Arabia, our MENA economist believe a drop to USD90/bbl would be just about manageable: certainly, its surplus would turn to deficit, but with FX reserves equivalent to more than two and a half years' worth of public spending, this looks affordable at least for now. Any move below this particularly on a sustained basis would be more painful (see A bitter legacy, 8 October 2013 for further analysis).

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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Fredrik Nerbrand, Stephen King and Daniel Fenn

Important Disclosures
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Additional disclosures
1 2 3 This report is dated as at 10 December 2013. All market data included in this report are dated as at close 09 December 2013, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

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Disclaimer
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Global Economics & Asset Allocation

Economics
Stephen King Chief Economist +44 20 7991 6700 stephen.king@hsbcib.com

Asset Allocation
Fredrik Nerbrand Global Head of Asset Allocation +44 20 7991 6771 fredrik.nerbrand@hsbcib.com Daniel Fenn +44 20 7991 3025 dan.fenn@hsbcib.com