abcGlobal 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 Fed tapers without a strong recovery

Fed is forced to increase QE

QE leads to inflation

Emerging-market risks China hard landing

EM current-account crisis

Developed-market risks Abenomics triggers financial instability

US debt ceiling not raised

Successful eurozone rebalancing

Good/bad price declines The spectre of deflation

Large oil price decline

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 Rumsfeld’s “known

unknowns”. We cannot say anything about “unknown

unknowns”. By definition, “black swans” cannot be anticipated.

Macro Global

Top 10 risks for 2014

Multi-asset special

10 December 2013

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 stephen.king@hsbcib.com

Daniel Fenn Strategist HSBC Bank Plc +44 20 7991 3025 dan.fenn@hsbcib.com

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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In any investment process, it is critical to consider

those risks that may not be part of one’s 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.

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

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1. Global risks landscape 2014e

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 Investment implications

QE uncertainty

Fed tapers without a strong recovery

Macro prudential concerns or overly-optimistic forecasts cause the Fed to act before a recovery is fully developed.

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.

Fed is forced to increase QE

Cyclical data surprises on the downside and the Fed expands asset purchases in response.

As growth stalls, riskier assets sell off as the success of QE is drawn into question. Treasury yields fall.

QE leads to inflation The recent years’ monetary policy has a lagged effect on price stability as output gaps may have closed more than previously believed.

Gold, metals and EM equities rally. US Treasuries sell off materially.

EM risks China hard landing 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.

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.

EM current-account crisis

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.

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.

DM risks Abenomics triggers financial instability

Cyclical data disappoints despite massive stimulus which would highlight that the structural problems are still present and potent.

JPY weakness on the back of further expectation of BoJ monetary support. Wider Asian markets do relatively well.

US debt ceiling not raised

Political polarisation leads to the debt ceiling not being raised and potentially to delays in coupon payments on US Treasuries

If an actual default occurs then cash is initially your only hiding place.After the initial volatility though, Treasury yields should fall.

Successful eurozone rebalancing

Wage growth in Germany and a reduction in its current account lead to improvements in the periphery’s external-demand outlook. EZ growth prospects recover and further integration efforts are implemented.

A slow burn positive risk. General risk premiums grind lower. Periphery spreads decline but equity markets would outperform fixed-income assets due to a rotation of asset allocations.

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.

Initially, eurozone equities would sell off before recovering on the prospect of outright QE by the ECB, which would also weaken the EUR.

Large oil price decline Supply-side shock from either an increase in production in MENA, shale oil, or a normalisation of Iran’s relationship with the rest of the world.

While oil and oil-related assets fall, equities do well and bond yields decline due to lower inflationary risks.

Source: HSBC

Fed tapers without strong recovery

Fed is forced to increase QE

QE leads to inflation

Abenomics triggers financial instability

US debt ceiling not raised

The spectre of deflation

EM current-account crisis

Large oil price decline

China hard landing

Successful EZ rebalancingMar

ket i

mpa

ct

Probability

QE uncertainty EM risks DM risks Good/bad price declines

Low Higher

Low

Hig

her

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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 Fed’s 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.

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

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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 Fed’s 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

1. There will be a shift in the relative dovishness of FOMC voting members in 2014

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

Esther George (Kansas President)

Eric Rosengren (Boston President)

Charles Evans (Chicago President)

James Bullard (St. Louis President)

Ben Bernanke (Chairman)

Janet Yellen (Vice Chair)

Jerome Powell (Governor)

Jeremy Stein (Governor)

Daniel Tarullo (Governor)

Sarah Raskin (Governor)

William Dudley (NY President)

Sandra Pianalto (Cleveland President)

Charles Plosser (Philadelphia President)

Richard Fisher (Dallas President)

Narayana Kocherlakota (Minneapolis President)

Perm

anen

t Mem

bers

Votin

g in

20

13Vo

ting

in

2014

DOVISH HAWKISH

Not voting in 2014 Still voting in 2014

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Macro Global 10 December 2013

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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

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.

We’ve 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).

QE leads to inflation

Although the debate about QE is now centred on

when the US is going to taper, this wasn’t 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 doesn’t, however,

mean that QE won’t 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

0

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Q4

2008

Q1

2009

Q2

2009

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Q2

2011

Q3

2011

Q4

2011

GDP growth estimate range (2011)Actual 2011 growth

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Macro Global 10 December 2013

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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

Source: HSBC

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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93 95 97 99 01 03 05 07 09 11 13

US labour-force participation rate

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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.

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 “China’s 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.

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

4. China managed to continue its growth path based on credit creation rather than exports

Source: HSBC, Thomson Reuters Datastream

-30-20-100102030405060

-30-20-10

0102030405060

Dec-04 Dec-06 Dec-08 Dec-10 Dec-12

Exports 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.

EM current-account crisis

While we remain optimistic about their long-term

growth prospects, we’re 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 Reserve’s 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.

It’s 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

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

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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Nov-10 Jun-11 Jan-12 Aug-12 Mar-13 Oct-13

BRL INR IDR ZAR TRL

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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 Abe’s 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.

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 Japan’s

problems are not demand-related alone. The lost

decades reflect an ageing population, a lack of

sufficient opportunity in the workforce for

Japan’s women, an absence of immigration and,

more generally, a reluctance to embrace

necessary structural reforms.

Imagine, though, that growth fades, inflation

doesn’t pick up sufficiently and reforms don’t

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 Japan’s recent history, none of this might

seem terribly likely but, when political promise

and economic reality don’t easily gel, monetary

instability is often an unfortunate by-product.

Developed-market risks

In Japan, Abe’s 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

6. Could Japan suffer a real-wage squeeze like the UK?

Source: HSBC, Thomson Reuters Datastream

-4

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01 02 03 04 05 06 07 08 09 10 11 12 13-4

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

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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 country’s 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.

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

government’s “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

7. Deteriorating demographics will continue to act as a drag on growth in Japan

Source: HSBC

-1.5%

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1950 1970 1990 2010 2030 2050

Japanese Marginal demographic index

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Macro Global 10 December 2013

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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

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 debt-

ceiling 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

politics trumps national politics. If, as former

Speaker of the House Tip O’Neill 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 Party’s poll numbers fell

more sharply than the Democratic Party’s

(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 public’s perception

of politicians.

9. Republican poll number fell relative to Democrats during the government shutdown and debt-ceiling negotiations

Source: RealClearPolitics

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.

0.2

0.4

0.6

0.8

1.0

1.2

0.2

0.4

0.6

0.8

1.0

1.2

1877 1897 1917 1937 1957 1977 1997

House polarisation Senate polarisation

-4

-2

0

2

4

6

8

10

-4

-2

0

2

4

6

8

10

Nov-12 Feb-13 May-13 Aug-13 Nov-13

Democrat-Republican generic Congressional poll spread

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Macro Global 10 December 2013

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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.

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). Germany’s 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 ECB’s

assumed target.

10. The German current account surplus has increased while deficits in the periphery have risen

Source: HSBC, Thomson Reuters Datastream

It’s 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.

It’s 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

-200

-100

0

100

200

-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

EURbn, 4QsumEURbn, 4Qsum Current account

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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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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

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 lower-

productivity 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.

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

11. Developed market consumer price inflation has fallen

Source: Thomson Reuters Datastream

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

US UK Germany Japan

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Macro Global 10 December 2013

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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.

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

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

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

4

5

6

7

8

Nov-03 Nov-05 Nov-07 Nov-09 Nov-11

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Macro Global 10 December 2013

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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.

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).

13. Global oil supply increases is not solely a US story

Source: IEA estimates, HSBC

- 0.5 1.0 1.5 2.0

Russia

Europe

Colombia

Process gains

Africa

Other FSU

Canada

Biofuels

OPEC NGLs

Brazil

USA

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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

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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

Global Economics & Asset Allocation