From macroeconomic considerations to geopolitical risk to China’s debt and business disruptions, we examine possible risk scenarios for portfolios that could shape 2018.

Quicker inflation may compel central banks to assertively tighten monetary policy

Since the depths of the global financial crisis, central banks have supported financial markets and the economies they serve through expansionary monetary policies. While we anticipate the scale of central bank support will diminish in 2018, we expect the overall shift to be slow and precise and will vary from one central bank to the next as they will be careful not to stifle current gains.

In our view, investors should continue to be cautious of financial repression and keep a careful watch on inflation as in some circumstances official data may appear to understate rising costs in the real world.

An unexpected increase in inflation cannot be ruled out. A sharp climb in oil prices, owing to a supply outage in the Middle East, is one outside risk. Another, and arguably greater, risk comes from the possibility of wages and prices increasing in the US and Germany. At 3.6%, German unemployment is at its lowest level since September 1980, is half the overall rate for the European Union and is the envy of the Continent. US unemployment is close to a post 1970s low at 4.1%.
While wage growth remains subdued for now in both countries, if it did accelerate dramatically, companies may face difficulty in hiring and force to increase wages to attract and retain staff. Alternatively, companies at full capacity and unable or unwilling to expand production would increase prices in an attempt to limit demand.

However careful central banks are in adjusting their monetary policies, the effects are uncertain. If it became clear that inflation is rising too quickly, central banks could be forced to increase interest rates quickly to restrain demand. This would augment the risk of recession. Note that every US economic downturn was preceded by a sharp increases in interest rates.

Geopolitical shocks could emerge from North Korea’s or political instability in the Middle East or uncertainty in the European Union or President Trump

Geopolitics is now the top risk for investors and it will retain the potential to destabilize the global economy in 2018. Investors have so far shrugged off the threat of a military conflict however, North Korea?s nuclear tests could have unintended consequences as the risk of a test missile hitting a country or a US military force conducting exercises in the region is still very high. If Japan or South Korea, the world?s third and eleventh-largest economies, are brought into any conflict, this will have global economic consequences.

Risks are also rising in petro-states from Venezuela to Nigeria to the Middle East. Sudden tensions could trigger an oil-price spike. Saudi Arabia is the world’s largest oil exporter and controls most of its 2.5-3 million barrels a day of spare capacity. The recent increase in tensions between Saudi Arabia and its neighbours (Iran and Qatar) has raised the risk of a disruption to oil supplies. If tensions escalate between Saudi Arabia and Iran, this could lead to disruption in oil exports that may lead to renewed sanctions on Iranian oil exports, pushing the price of a barrel of oil to around USD80 and remain at those levels for at least three-to-six months.

The EU?s future is not clear cut. We expect Brexit negotiations to grow tenser as the UK?s departure deadline looms. Italy?s upcoming election poses a tail-risk to European stability as the country struggles under its debt burden. Further risks may come from Irish and Russian Presidential elections.

President Donald Trump?s tax reform proposal represents a potential flashpoint ahead of mid-term elections in November. The mid-term elections represent another critical moment for the Republicans and a litmus test on Mr Trump?s own popularity.

In addition to monitoring possible global flashpoints as outlined above, investors will need to consider domestic political developments to assess their probable effect on monetary and fiscal policies. Globalisation is resented by many voters as they feel squeezed by austerity and sense that inequality is rising. Politicians may be forced to respond.

China?s rising debt levels could lead to a greater-than-expected economic slowdown.

China?s economy begins 2018 continuing its three-year approach outlined by the country?s top leaders in tackling debt, pollution and poverty. These issues pose risks to the domestic economy even before taking into account threats of a trade war with the U.S. and growing regional tensions that could have global ramifications to economic growth with the Asia Pacific region particularly vulnerable from a slowdown.

Since 2008, the level of debt owned by Chinese non-financial corporations, households and governments has risen by more than 100% of GDP. We estimate that China?s total debt will reach 327% of GDP by 2022 putting China among the most indebted countries in the world. As the debt burden grows, so does concerns of financial stability.

We have identified several large Chinese companies in aviation, insurance and property that are already showing signs of credit problems. Other concerns relate to trusts and shadow banking, which refers to lending that happens outside the formal banking sector. For the moment, our view is that China will experience small-scale credit crunches concentrated to these sectors and local governments having problems to hit growth targets and fund infrastructure work. However, if these defaults start to spread and fear begins to form, then this will have implications on the wider economy. Should this occur, the Chinese government would likely have sufficient resources to prevent it from spreading, however global market volatility could increase until the situation is controlled.

We note that while China?s government have taken steps to try and prevent debt levels getting out of control and improve overall financial stability in recent years, through targeted regulation, more still needs to be done.

Global Property Bubble could bust in certain cities

We also mention the potential bursting of housing bubbles in Australia, Canada, China, Norway or Sweden. Toronto has the greatest risk of the property market bursting helped by low mortgage rates and an influx of Chinese investment.

Stockholm, Munich, Vancouver, Sydney, London and Hong Kong all remain in risk territory, with Amsterdam joining this group after being overvalued last year. Valuations are stretched in Paris, San Francisco, Los Angeles, Zurich, Frankfurt, Tokyo and Geneva as well.

The global economy is doing reasonably well ? but growth is becoming patchier and there remains political and policy risks. Regional differences are likely to become more pronounced. At the same time, many assets appear richly valued. Consequently, investors will need to be increasingly selective in 2018.

HXL Partners

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