Wednesday, January 7, 2015

Dominant and contrarian visions of 2015

It's that time of the year when seemingly every economist in the private sector puts together an economic outlook for the year ahead. I'm not foolhardy enough to make predictions, or even to pretend my crystal ball is less cloudy than others'. I'm writing this post because I am bothered by the extreme prevalence of some "consensus views." For example: the narrative of divergence between the U.S. and the eurozone. Or the widely shared belief that Syriza will lead Greece out of the eurozone. 

I have put together a list of (what I see as) dominant views--it's not fair to call them "consensus"--, as well as possible alternative scenarios that don't get as much attention as they should. Time will tell.

Dominant view Contrarian view Dark-horse view
U.S. dollar Fed raises rates, and the U.S. economy outperforms that of the eurozone, Japan, and emerging markets, leading to a big appreciation of the U.S. dollar relative to most currencies. Grexit and the failure of Abenomics add more fuel to the run-up of the dollar. The eurozone's economy performs better in 2015 than in 2014, the ECB delivers little or no QE, and Japan's growth and inflation turn out higher than expected. The dollar depreciates from the level of late 2014.
Monetary policy Divergence between Fed, on one side, and BoJ and ECB on the other. Tightening begins in the U.S., whereas ECB and BoJ commit to zero interest rates for the foreseeable future. Rapid disinflation lifts real interest rates. The Fed turns more dovish, and policy rates rise less than anticipated, supporting asset prices. Faster-than-expected growth, and recovering oil prices change the Fed's inflation outlook, prompting aggressive tightening.
Inflation Inflation stays low in most countries. In the U.S., core inflation remains stable, then rises, as labor market tightens. Eurozone enters deflation, briefly, before base effect of low oil prices is phased out. U.S. core inflation falls, scaring the Fed into postponing interest rate hikes. Eurozone falls into deflation, which proves to be more persistent than anticipated. "Japanization" narrative becomes mainstream. Oil price rebound puts disinflation behind, at least for now.
U.S. bonds Long-term interest rates rise, in anticipation of the Fed's tightening "in mid-2015". The yield curve flattens, due to low expectations for medium-term growth and inflation. Slow growth and ultra-low inflation push long-term yields even lower. Monetary policy tightening happens faster than expected. Growth surprises on the upside. Long-term yields rise sharply. The yield curve steepens despite Fed's tightening.
U.S. equities Gradual withdrawal of Fed support + Pick-up in economic growth = Elevated profits and valuations persist --> Positive returns, but lower than in 2014. The Fed is even more cautious than expected, and puts off interest rate hikes, perhaps due to ultra-low inflation. Investor enthusiasm turns into mania. IPOs and M&A activity bubble up. Valuations approach those of the late 1990s, raising the risk of a crash in the short term. Fundamentals of 2009-2014 bull market prove fragile. Faster-than-expected monetary tightening crushes equities.
Oil Plentiful supply and sluggish demand keep prices in $50-$80 range. Disruptions to supply in MENA push prices back up to the $90-$120 range. Recession in China pushes price under $50 for several months.
China Soft landing, with bumps. "Lowflation" persists, pernicious deflation is avoided. Excess capacity is worked out slowly; government doesn't need to officially bail out the financial sector. Slowdown escapes Beijing's control. Sharp recession and deflation set in, but government steps in to save the day, nationalizing several financial entities. Commodities plunge, several countries in Latin America enter recession, financial crises engulf a few EMs. Volatility spikes in all the world's main financial centers. China's slowdown proves temporary. GDP growth rebounds north of 8%. Commodity prices rebound.
Japan Fresh monetary stimulus succeeds at first. Yen depreciates, Japanese firms gain market share and increase profits. Core inflation remains positive, but eventually starts falling again, prompting the gov't to provide, eventually, more stimulus. New round of monetary stimulus fails to keep inflation up. Deflation returns, spurring the gov't to provide new stimulus, soon. Domestic demand, inflation expectations, inflation grow faster, setting off a "virtuous cycle" that leaves deflation behind forever. Abe's third arrow gets implemented, raising potential growth.
India Lower commodity prices boost economy and improve fiscal position. Modi pushes through reforms, lifting potential growth and dampening core inflation. Equity bull market continues. Global environment supports Indian growth, but Modi can't push reform as quickly as expected, due to internal political obstacles. Equities lose some steam, but there is no collapse. Rupee sell-off triggered by rising U.S. interest rates, contagion from Russian crisis to other EMs, etc. Foreign exchange reserves shrink precipitously, financial crisis looms.
Russia Recession deepens. External debt crisis looms, but is narrowly avoided. Short-lived dip. Growth resumes thanks to rebound of oil price. Persistently lower oil prices push Russia into full-blown external debt crisis. Banks fail. IMF comes to the rescue.
Greece Syriza wins the Jan. 25 elections, or gets enough seats to form a coalition led by Syriza. Greece requests a debt restructuring (i.e. partial default), which the troika rejects. Grexit. Syriza wins the Jan. 25 elections, but doesn't obtain majority. They call new elections. By then (March), Greeks get scared out of leaving the euro. Syriza loses votes in the second election. A coalition of moderate parties forms, and in the nick of time Greece commits to reform in exchange for more time and money from troika. Greece stays in. Syriza gets crushed in the polls, and stays out of gov't. ND forms a coalition. Stability returns, for now.

1 comment:

John P said...

Francisco, thanks for the great post. Your dark horse inflation scenario actually seems pretty likely to me. When the oil price recovers and the CPI and pump prices zoom accordingly, how will consumers businesses and the media process the news? Why wouldn't they see it as "inflation is back" and release demand accordingly? Actually I wonder why this scenario isn't discussed much, your blog is the only place I found it.