rge the year ahead roubinis top 10 macro themes

BIG PICTURE

ROUBINI RESEARCH +1 (212) 645 0010 NEW YORK [email protected]

YOUR INSIGHT MULTIPLIER +44 (0) 207 092 8850 LONDON [email protected]

+65 6434 8890 SINGAPORE [email protected]

© Roubini Global Economics 2014 - All Rights Reserved. No duplication or redistribution of this document is permitted without written consent.

1

Page | 1

December 3, 2014

The Year Ahead: Roubini’s Top 10 Macro Themes By Nouriel Roubini and the Roubini Research Team

As we move into 2015, and complementing our Q1 Global Outlook, we list our top 10 key macroeconomic themes

and explore the risks to our baseline views. This draws and expands on our recent piece: “Looking Into the Crystal

Ball: Roubini's Key Research Issues for 2015 and Beyond.” Look out for the forthcoming companion paper on our top

10 asset class themes, which maps market ideas to our key macro views.

1. Global Growth Is Battered and Bruised, but Unbroken (Thanks to the U.S.).

2. China Is Slowing Far Faster Than Consensus and Heading for a Bumpy Landing

3. Europe Faces a Challenging Year, With Politics a Key Risk

4. Oil (and Commodity) Glut: Oil Weak, Metals Worse—Producers Hit, but Good for Growth and Inflation

5. DM Inflation: “Still No Bark” as Disinflation Reigns

6. Monetary Policy Divergence in G4, but Still Dovish Overall, With Currency Wars by Proxy

7. Fed Exits—but Not as Early or Fast as Most Expected

8. Some EMs Find Space to Ease/Slow Tightening and Allow FX Weakness, but Others Face Headwinds

9. Bubbles in Risk Markets (From Housing, to Credit, to Equity), With Macropru Nearly Toothless

10. Low Volatility, Low Returns and Suppressed Business Cycle Will Give Way to Bouts of Volatility

EXECUTIVE SUMMARY

1) Global Growth Is Battered and Bruised, but Unbroken (Thanks to the U.S.)

The U.S. and the rest of the Anglosphere (including the UK and Canada) is now the world’s key growth engine,

but domestic drivers amounting to less than 30% of global GDP aren’t enough to support global growth.

Other parts of the world remain anemic. As in the mid-1990s, there is a marked divergence in growth within

the DM world, between the faster-growing U.S. and UK and the anemic eurozone (EZ) and Japan.

There is less fiscal drag in DMs, but no meaningful positive fiscal impulse to sustain aggregate demand.

Meanwhile, painful public and private deleveraging continues, albeit more slowly.

China and the EZ are the main weak spots, but commodity producers are also vulnerable, as investment

disappoints and fiscal revenues collapse.

This year’s EM growth laggards—such as Russia, South Africa, Brazil and Thailand—will likely show some

growth improvement, but there is no strong move toward reforms. Reformers—Mexico and India—will likely

accelerate.

Many EMs are highly exposed to China (especially via commodities), but few are highly leveraged to the U.S.

Risks to our view: China might slow by less than we expect and EZ growth could surprise to the upside.

And/or the U.S. could surprise to the downside, given global shocks and an excessively strong dollar.

BIG PICTURE





2

Page | 2

2) China Is Slowing Far Faster Than Consensus and Heading for a Bumpy Landing

Markets will be surprised as growth slows toward 6.5% in 2015, as rebalancing from investment- to

consumption-led growth is delayed, and sub-6.0% growth in 2016 comes into focus.

The investment slowdown continues, and reforms to support consumers are being implemented too slowly.

Bad assets, bad debts and bad investment are mounting, leading to higher fiscal costs to clean up excesses.

China’s slowdown will increase global disinflationary pressures through two channels: Commodities and the

dumping of the glut of domestic manufacturing capacity on the global market.

EM Asia, Latin America and other commodity exporters (especially of industrial metals) will see their exports

performance suffer—more currency depreciation is likely and more competitive devaluation.

Local equities will remain pressured; notably, banks and regional property markets (such as in Singapore and

Hong Kong).

Risks to our view: China might slow by less than we expect (a softer landing) if the government assumes all

the financial system’s losses or by more than we expect (a harder landing) if easing policies cannot contain

the sharp fall in fixed investment.

3) Europe Faces a Challenging Year, With Politics a Key Risk

German and Spanish growth will slow, and Italy and France will struggle to exit/stay out of recession. Huge

output gaps, high unemployment and downward wage pressure create a chronic disinflationary (and

possibly deflationary) environment.

The ECB will respond with further monetary easing including formal QE (corporate and sovereign bond

purchases), but this will be too small and less aggressive than desirable. Moreover, political-economy issues

will be complicated, as Germany, the EU and the ECB try to keep the pressure on more fiscally problematic

countries.

The EU’s €315 billion investment plan (only €21 billion is from public sources, the rest is leverage) is too little,

too late and too complex to have a meaningful impact.

A cycle of elections will take place in most of the periphery: Presidential elections possibly leading to early

general elections in Greece and Italy in H1; general elections in Portugal and Spain in H2. And the UK general

election in May will have repercussions for the whole of the EU.

The rise of anti-system parties (such as Syriza, the Northern League, the Five-Star Movement and Podemos)

could put structural reforms and austerity at risk. And geopolitical tensions remain high, with the

Russian/Ukrainian crisis unresolved (impacting investment sentiment in Germany).

Non-EZ European countries are doing better, such as the UK, Switzerland, Sweden and Norway, but might

need to use additional conventional and unconventional policy measures to avoid deflation and excessive

currency appreciation, with the Bank of England (BoE) delaying the start of its tightening cycle.

Risks to our view: EZ growth could surprise to the upside given easier financial conditions and lower oil

prices, with surprisingly courageous leaders grasping the nettle of structural reform and taking on vested

interests.

BIG PICTURE





3

Page | 3

4) Oil (and Commodity) Glut: Oil Weak, Metals Worse—Producers Hit Skids, but Good for Growth and Inflation

The oil price slump is a clear positive for the global economy (bringing with it higher growth and lower

inflation), but producers lose out as consumers win.

Oil prices will stay under pressure in H1, testing new cycle lows, and stabilize at around $85 by year-end

2015 on production cuts.

Producer countries that allow FX adjustment (such as Russia and Mexico) will still see their trade balances

worsen, but by a smaller amount than otherwise.

EMs’ high “energy intensity” implies the price slump benefits EM consumers more than DM ones.

Energy capex will be curtailed, even in the U.S., as prices remain below investment break-evens.

Other commodities will stay soft (such as industrial metals and gold) given the weaker China and stronger

dollar.

Risks to our view: Oil prices might remain under $70 per barrel, with Saudi Arabia refusing to limit

production sufficiently, and the supply-demand balance might remain bearish.

5) DM Inflation: Still No Bark as Disinflation Reigns

Low core inflation continues to plague inflation-targeting central banks on slack demand, slack labor

markets, high real exchange rates and weakening inflation expectations.

It gives central banks leeway to delay rate increases (for example, the Fed, BoE, Bank of Canada—BoC,

Reserve Bank of Australia—RBA) or ease further (the ECB, Bank of Japan—BoJ, Swiss National Bank—SNB

and Riksbank) in DMs. Also, EMs with low inflation can ease more.

The suppressed term premium will keep 10-year bond yields below the nominal GDP outlook; long rates in

the U.S. and UK will rise, but only slowly, and will remain below 1% in the EZ and Japan.

Risks to our view: Long yields in the U.S. could rise by more than we expect (above 3%) as stronger growth

and higher inflation lead to an earlier and faster exit from ZIRP.

6) Monetary Policy Divergence in G4, but Still Dovish Overall, With Currency Wars by Proxy

The BoJ will top-up its quantitative and qualitative easing (QQE), leading central banks in Asia and Europe to

ease more to avoid excessive currency appreciation. We will see a new round of QE and “easier money wars”

as proxies for currency wars as domestic demands sags.

The Fed and BoE will “lift off” in 2015, even if later and more slowly than we expected (on lower global

growth and stronger currencies), but the BoJ will continue open-ended QQE. Low EZ growth and inflation

will affect the UK more than the U.S., leading to divergence between the two central banks that are cyclically

most advanced.

The EZ is especially weak, and will force the ECB into action, buying sovereign and corporate bonds (formal

QE).

Policy divergence will keep EUD and JPY under pressure, ending 2015 at $1.15 and ¥1.28, respectively.

BIG PICTURE





4

Page | 4

Risks to our view: U.S. and UK growth could surprise to the downside if weaker global growth and

dollar/pound strengthening are more than we expect. On the other hand, wage pressure could be greater

than under our baseline, forcing the Fed and BoE to begin policy normalization sooner. Japan and the EZ

could surprise to the upside growth-wise if easier policy-driven financial conditions boost demand more than

we expect.

7) Fed Exits—but Not as Early or Fast as Most Expected

We think the low expected core inflation, high dollar and weaker global growth will keep the Fed on hold for

longer, until Q3, before it starts to hike.

Currently there is an “average” market view of two hikes in H2 2015 and three or four in 2016, but there is

uncertainty around that scenario. The Fed will seek to avoid expectations of faster tightening… for now.

Wage growth pass-through to core inflation will stay weak due to the persistent real wage/productivity gap.

The struggle to buoy inflation expectations may intensify.

Financial-stability consideration may persuade the Fed to start hiking sooner and faster (if gradually) since

macropru policies to contain asset and credit bubbles are likely to be ineffective;

Risks to our view: The Fed could exit faster than we expect if growth remains strong, the labor market

tightens faster than we think it will, if inflation picks up sooner and if financial excesses lead to a melt-up in

risky assets or excessive releveraging of the real and financial system. Or, the Fed could stay on hold through

into Q4 or even 2016 if global growth headwinds and dollar strength adversely affect the domestic economy.

8) Some EMs Find Space to Ease/Slow Tightening and Allow FX Weakness, but Others Face Strong Headwinds

EM central banks need to do less tightening due to the weak oil prices, dovish Fed and peaking inflation.

Some (for example, India, Russia, Poland and South Korea) may even be able to cut rates.

India, Mexico and parts of Southeast Asia are pulling ahead of the rest on reforms, flattening curves.

Oil- and commodity-exporting EMs are hurting.

There is a risk of “credit events” in Ukraine, Venezuela and some of the smaller frontier economies.

We prefer EM local debt to FX, and are selectively positive on EM equities (South Korea and Poland). EM

external debt does not compensate for risks (especially with regards Turkey, Brazil and South Africa).

Forward bond rates look too low in “safe haven” EMs like South Korea, Hong Kong, Taiwan, and will sell off

more than U.S. Treasurys as the Fed’s tightening gathers steam.

Risks to our view: We could see reversals of fiscal and monetary adjustment, an underperformance of

structural reforms, too much micro-managing, deep cuts to public investment that threaten credit ratings

and/or a less supportive external environment.

9) Bubbles in Risk Markets (From Housing, to Credit, to Equity), With Macropru Nearly Toothless

Major central banks will prioritize boosting growth and inflation over their financial-stability mandates,

fueling more asset and credit frothiness and inflating bubbles.

HY and CLOs will stretch further into overvaluation, while covenants will continue to ease.

BIG PICTURE





5

Page | 5

Froth may spill into strong equity sectors and some housing markets.

Central banks will respond with underwhelming and largely untested macroprudential policies rather than

hiking rates sooner/faster.

Risks to our view: Perhaps macropru policy will actually work and, eventually, pass the baton to tighter

monetary policy once the economic recovery is more robust, thus controlling the risk of asset bubbles.

10) Low Volatility, Low Returns and Suppressed Business Cycle Will Give Way to Bouts of Volatility

Central bank policies continue pump liquidity into markets.

Ex-ante volatility will remain near historical lows in DMs for equities, but not for rates and FX.

Volatility spikes will be short-lived, but could be violent due to the high volatility of volatility, exacerbated

by poor liquidity conditions, ETF “herd mentality,” and market-makers’ reduced risk capacity.

Risks to our view: We could see bouts of market volatility and persistent market corrections as macro data

(from China and the EZ), policy and geopolitical surprises occur and market liquidity structurally shrinks.

EXPLORING OUR VIEWS IN DETAIL

Global Growth Is Battered and Bruised, but Unbroken (Thanks to the U.S.)

Global growth in 2015 will be only marginally better than in 2014, with broad differentiation and divergence within

both DMs and EMs. Within DMs, the U.S. and UK will grow faster than potential, but Japan and the EZ will grow

below potential (in fact, below 1%). However, Japan at least will experience a growth recovery after a dismal 2014—

the EZ will remain virtually stagnant.

The main themes for 2015 will be: China’s growth slowdown and its external effects amid slow rebalancing and

reforms; Europe’s stagnation, near deflation and mounting political risks, only tempered by QE (albeit too little too

late); Japan’s struggle to jump-start growth and inflation with more QQE and a delay of the second consumption tax

increase after the botched 2014 hike; and the U.S., the UK and selected EMs growing faster and partially decoupling

from the rest of the world’s growth malaise.

Thus, the world will keep on flying on a single U.S. (and Anglosphere) engine, with the other three main engines—

the EZ, Japan and China—stalling or sputtering to different degrees. Deleveraging from high debt levels isn’t over for

most DMs even if it is more advanced in the U.S. We expect China to slow to sub-6% growth in 2016, and the EZ’s

failed efforts to reflate imply low-inflation and weak growth, and possibly a political backlash.

Weak commodity prices—primarily, oil—create both winners (oil/commodity importing economies) and losers

(oil/commodity exporters), and slack in goods and labor markets will keep inflation too low in most DMs and many

EMs. This means that central banks in DMs and EMs alike will be able to postpone hikes (for example, the Fed and

BoE), or stimulate more if needed (the BoJ, the ECB and many other DM and EM central banks). Currency wars—via

proxy QE or conventional monetary easing wars—will continue as many countries (given weak domestic demand)

will try to boost growth via net exports driven by weaker currencies. The BoJ’s recent topping up of QQE has triggered

and will continue to trigger easing reactions in Asia (Singapore, Thailand, China, Taiwan and South Korea) and all

over Europe (the EZ, Switzerland, Sweden, Norway and parts of Central Europe). Eventually, this pressure will feed

into a stronger dollar and may persuade the Fed to exit later and more slowly from ZIRP to avoid importing weaker

growth and deflation from the rest of the world.

BIG PICTURE





6

Page | 6

The U.S. however, is poised to recover toward potential, and may grow at an above-potential rate for several years,

although an excessively strong dollar and weak global growth could still lead to (partial) recoupling. Stronger U.S.

growth will benefit a few of its neighbors and close trade partners (Mexico, Canada, the UK, Colombia, South Korea

and other newly industrialized countries—NICs), as well as EMs that are more aggressive on the reform front, such

as India, Mexico and, possibly, Indonesia. Some 2014 EM laggards—Russia, South Africa, Brazil, Thailand—may see

a modest improvement in their anemic growth rates. The fortunes of EMs will depend on four key factors: Exposure

to the U.S. economy and Fed; exposure to China; dependence on commodities; and the capability to implement

macro adjustments and structural reforms when necessary.

Geopolitical risks will linger and may lead to temporary bouts of volatility, but their impact will be felt first through

economic contagion and risks before the markets become infected (with accommodative monetary policies

containing the latter).

Market-wise, this baseline scenario implies: A stronger dollar relative to some DM and EM currencies; long rates in

the G4 staying low (even if gradually rising in the U.S. and UK); lower commodity prices especially for oil/energy and

industrial metals; global equities providing single-digit returns, with an increased number of drawdowns; U.S.

equities becoming increasingly toppy; EZ equities (especially in weaker EZ economies) struggling, despite the coming

ECB QE, given weak growth and near deflation; and EMs outperforming DMs selectively (the aggregate remains

under pressure from the China slowdown), with great differentiation (stronger performances from oil-importing,

reforming and macro-adjusting economies).

Easy monetary policies imply that frothiness in some credit, fixed-income, housing and equity markets will continue

to build up. Volatility may remain suppressed, given the still accommodative monetary policies in DMs and EMs, but

bouts of volatility and market corrections (like in August-October) will emerge as economic, political and geopolitical

surprises interact with lower market liquidity (and crowded short VIX trades) and stretched valuations in an

increased number of asset classes. One cannot also rule out the Fed starting to hike sooner (despite the low inflation

and slack in labor markets), if gradually, as macropru policies are likely to be ineffective, while a slow exit would lead

to rising concerns about financial stability and the building up of asset and credit bubbles.

Risks to Our View

China could slow by less than we expect as policy makers decide to kick the can down the road for another year and

keep growth closer to 7% with another round of significant monetary and credit easing; and lower oil prices could

also boost Chinese growth and net exports. Moreover, EZ and Japanese growth might surprise to the upside as lower

oil prices, easy financial conditions (weaker euro and yen, low short and long rates, low credit spreads and rising

equity markets) and reduced fiscal drag boost growth by more than we expect. Overall, the world could perform

better than we expect given the potential beneficial effects of lower oil and commodity prices, lower inflation

(boosting consumption), relatively easy monetary policies and slow exits with less fiscal drag than in previous years.

The U.S. may surprise to the downside—growth-wise—if the dollar becomes too strong and the rest of the world is

weaker than even our anemic outlook would suggest, while geopolitical and other shocks trigger bouts of market

volatility and persistent correction. U.S. growth could also surprise to the downside on domestic drivers. Part of the

household sector is asset-less, and still debt burdened and income challenged, so it may not be able to cope with

the magnitude of the rise in short and long rates that a quick Fed exit might entail. Rising inequality also depresses

labor income and consumption. Moreover, interest rate-sensitive sectors—such as housing and capex—would come

under pressure if the Fed exits too soon, leading to “rate rage” (equivalent to the “taper tantrum” after the Fed

announced its QE exit).

BIG PICTURE





7

Page | 7

China Is Slowing Far Faster Than Consensus and Heading for a Bumpy Landing

One of our key below-consensus views for 2015 is on Chinese growth. The two extreme views on China—the

consensus and government view of a “soft landing,” with growth staying at 7% or above, and the “hard landing”

view of some analysts that growth will crash to 4% or below—are in our view incorrect. We see China suffering a

below-consensus “bumpy or rough landing,” with growth slowing to 6.5% in 2015 and 5.4% in 2016. Markets

(commodities, China/Asia equities, etc.) do not price this in.

The necessary rebalancing from fixed investment to consumption (which requires the rapid front-loading of the

reforms announced at the Communist Party of China’s (CPC) Third Plenum in 2014) has been delayed, with President

Xi Jinping is trying to consolidate his power and distracted by foreign policy and other domestic issues. Also, any time

growth falls below 7%, the authorities respond with another round of credit-fueled fixed investment that increases

bad assets in banks and shadow banks, bad investments in real estate, infrastructure and industrial capacity, and

bad debts in the private and public sectors (leverage is now over 200% of GDP and still rising). By 2015, the

authorities will likely allow a slowdown in growth, a reduction in credit growth and some reforms (albeit slower than

is optimal) as Xi’s power becomes even more established and as the alternative of kicking the can further down the

road risks an eventual harder landing.

China’s slowdown will increase global disinflationary pressures through two channels. First, lower commodities

prices, especially for industrial metals. Second, the dumping of Chinese manufactured and industrial goods on global

markets, which in turn will suffer from gluts of capacity and slowing domestic demand (such as steel, cement, etc.).

China’s political and geopolitical risks should be manageable even if at times they lead to volatility spikes. Japan and

China have started a process of rapprochement, with a brief hand-shake (at the Asia-Pacific Economic Cooperation

summit) in an effort to cool their territorial dispute, although this issue will not be resolved for years. The crackdown

in Hong Kong is likely to be mild and non-violent, even if the territory remains a sore point for China. China will move

tactically closer to the other revisionist power, Russia, as it makes economic and geopolitical sense. The U.S. and

China are engaged in a constructive dialogue even if the two sides view each other with long-term strategic wariness.

The U.S. pivot to Asia is increasing, with the two countries increasingly competing for hegemony in Asia and the

Pacific. At home, Xi will successfully consolidate his power even if anti-reform lobbies are still influential, but he will

be neither a radical reformer like Deng Xiaoping nor a conservative enforcer of the CPC status quo like Mao Zedong.

Market-wise, EM Asia, LatAm (Chile, Peru and Brazil) and other commodity exporters in EMs and even DMs, such as

Australia (especially producers of industrial metals, such as copper and iron ore), will feel the hit to exports. They

will respond with more currency depreciation and more competitive devaluation given the shock to their terms of

trade. Local China equities will remain under pressure, especially banks, state-owned enterprises (SOEs) in the

resource sector and real estate firms, but lower oil prices should help Chinese equities, like those of other major oil-

importing economies. Other frothy regional property markets (such as Singapore and Hong Kong) may also face a

downturn to parallel that of China.

A sharper Chinese slowdown due to investment, with banks and developers’ earnings contracting, will prevent

aggregate EM earnings from outperforming the strong DM earnings performance (led by a strong U.S.). Some export-

facing sectors might deliver better-than-expected earnings performance, but this would be unlikely to be enough to

offset the negative effects. So, underperforming earnings coupled with post-reform higher real rates will remain a

drag on the aggregate EM performance.

BIG PICTURE





8

Page | 8

Risks to Our View

China could of course slow by less than we expect (a softer landing) or more than we expect (a harder landing).

Growth of 7% will occur only if the authorities recklessly double down on yet another round of credit-fueled fixed

investment, thus increasing the risk of a harder landing in 2016 and beyond. Also, the fall in oil prices may boost net

exports and lead to an upside growth surprise, and thus prevent a modest depreciation of CNY that some expect.

Growth below our view could occur if China botches the adjustment and triggers a run on shadow banks with an

excessive crackdown on moral hazard. Also, the ability of China to fine tune its slowdown is uncertain as the

authorities do not fully control the investment and spending decisions made by real estate firms, local governments,

SOEs and private firms. Recent data confirm that Chinese growth could continue to surprise to the downside.

Europe Faces a Challenging Year, With Politics a Key Risk

We expect EZ growth to remain subdued, with Germany and Spain decelerating, and Italy and France struggling to

get anywhere beyond stagnation at best. Huge output gaps, high unemployment and downward wage pressure

create a chronic disinflationary, and possibly deflationary, environment, especially in the EZ periphery, but also in

the core. Even if the proposed recipe (with a special emphasis on structural reforms) works, disinflation/deflation

would be the most likely outcome. Spain, an example of “good deflation,” shows that effective structural reforms to

regain competitiveness lower costs, and therefore the economy’s entire price structure. Italy, where de-

industrialization has wiped out entire sectors of the economy, is an example of “bad deflation.”

The complicated nature of EZ politics is behind the ECB’s pained efforts to arrive at the obvious and necessary

destination of sovereign QE too late, and to do not “whatever it takes” but only “the minimum necessary.” And fiscal

policy will not impart the strong positive demand impulse that the EZ needs, as Germany will do no stimulus (despite

its sharp slowdown), the Jean-Claude Juncker plan for €315 billion of investment is mostly pie in the sky, and France,

Italy and the periphery are still on a tight EU fiscal leash, implying merely less fiscal drag, rather than the needed

stimulus. Weak government leadership means supply-side and other structural reforms will occur only slowly. QE,

easier financial conditions and a weaker euro will ward off deflation, but too-low inflation will still be the outcome.

Next year will see a series of elections in Western Europe. Greece, Spain, and the UK will all head to the polls, with

anti-establishment parties in each threatening to upset the traditional order. Italy’s hapless prime minister, Matteo

Renzi, could end up facing a mutiny, given the economy is still sinking and his promised reforms have not been

approved. After him may come even less credible governments, with the leader of the Northern League, Matteo

Salvini on the rise (having adopted the approach of Marine Le Pen, of France’s far-right Front Nationale—FN).

In Greece, Syriza could win the general election, and threaten to leave the euro unless the country receives

significant debt relief. In Spain (the poster child of structural reforms), Podemos—a radical anti-euro party—is rising

in the polls. France is in a serious policy and political bind as austerity and reforms occur more slowly than expected,

and the radical FN becomes more powerful. And the UK may get another hung parliament at its May general election,

while the chances of an eventual “Brexit” from the EU rise if—as likely—the UK cannot get the EU to agree to allowing

restrictions on labor mobility within the bloc.

At an EU level, we have seen numerous “grand coalitions” preserve the status quo, but at a national level, “fruitcakes

and loonies” may end up sharing power. The elites’ political faith in the euro is intense, but the single currency—a

“historical monument to collective folly,” in the words of UK politician William Hague—may eventually (by 2016-17)

BIG PICTURE





9

Page | 9

come under renewed threat if debt sustainability remains out of reach and growth stays anemic, as will the UK’s

commitment to the EU.

Increasingly, the bargain between Germany and the periphery—“you do austerity and reforms, however slowly, and

we will be patient and provide you with funds directly and indirectly (via the ECB)”—is fraying, given reform and

austerity fatigue in the periphery and bailout fatigue in the core (as seen in the rise of anti-euro right-wing parties).

And while the nation state is in crisis in the EU, sub-national fragmentation is also a risk—Catalonia in Spain, the

North of Italy resentful of a weak “Mezzogiorno,” Scotland in the UK, the Flemish-Walloon rivalry in Belgium, etc.

Non-EZ European countries will do better growth-wise, but countries such as the UK, Switzerland, Sweden and

Norway might need to use additional conventional and unconventional policy measures to avoid deflation and

excessive currency appreciation, with the BoE now likely delaying the start of its tightening cycle.

Russia’s more aggressive stance—not just toward Ukraine—but also toward the West in general and the EU in

particular will lead to a near cold war. Nationalistic and Slavophile forces in the Kremlin are getting the upper hand,

even relative to the hawkish Russian President, Vladimir Putin, and pushing for expanding the influence of Greater

Russia beyond Central Asia and Ukraine all the way to the orthodox religious Slavic axis that includes Serbia, Bosnia-

Herzegovina, Bulgaria, Moldova and even Catholic Hungary (President Viktor Orban’s “Orbanomics” is a copy of

Putinomics’ state capitalism and illiberality). Thus, tensions between Russia and the West are likely to escalate rather

than become milder. Given the direct threat that this Russian stance poses to a fraying EU and EZ, Germany will

accept policy easing—ECB QE—that prevents the short-term tail risk of an EZ break-up. But it will not support more

aggressive monetary and fiscal policies to restore stronger growth in the EZ.

The market implications of our baseline are clear. First, a weaker euro. We expect it to fall to $1.15 by end-2015—

although this is driven more by rising yields in the U.S. than by a sharp monetary expansion in the EZ. Second, low

yields in the core and even lower spreads in the periphery. Third, a mixed stock market, where Germany and Spain

can outperform France, Italy and the periphery, but where lukewarm QE does not trigger the same sustained equity

rallies that QQE triggered in Japan.

Globally, EZ earnings growth has disappointed the most this year, with 2014 and 2015 EPS expectations seeing the

largest revisions. We expect more of the same next year, with the current bottom consensus EPS growth forecast

for 2015 at 15% versus Roubini’s 5.6%. This lack of momentum in GDP and earnings growth coupled with the ECB’s

slower-than-optimal reaction to deflation risks in a rising U.S. rate environment is likely to lead to an unchanged

valuation (at best), if not multiple contraction, despite short-term QE-related rallies.

Risks to Our View

We could see an upside surprise to growth in the EZ, both in the core and periphery. This more optimistic outlook

would depend on oil prices falling even more, aggressive QE and a more positive fiscal impulse than we predict, and

even easier financial conditions. There is an upside risk that QE could spark a sharp weakening of the euro, a fall in

core yields and periphery spreads, and a strong rally in EZ equities.

Oil (and Commodity) Glut: Oil Weak, Metals Worse—Producers Hit Skids, but Good for Growth and Inflation

The price slump in oil—and some other commodities—has been driven by several factors. First, faster supply growth,

given the shale revolution in North America and the greater supply of many commodities, with capacity increasing

after many years of high prices. Second, weaker demand as the EZ and Japan are anemic, and China and many EMs

are slowing. Third, the Fed’s gradual exit from ZIRP will lead to a stronger dollar and lower dollar price for many

BIG PICTURE





10

Page | 10

commodities. Fourth, for oil, Saudi Arabia is willing to keep production high (no OPEC agreement on production cuts).

Shale producers in the U.S. and other producers in OPEC and non-OPEC countries will be forced to mothball many

new projects that were supposed to increase capacity. And, lower oil prices will hurt Saudi Arabia’s geopolitical

enemies, such as Russia and Iran. Thus, energy capex in gas and oil has been curtailed, even in the U.S., as prices are

now below investment break-evens for the most expensive projects.

Whether oil prices remain low through most of 2015 or rebound at some point depends in part on Saudi Arabia’s

strategy. On the one hand, Saudi Arabia may be willing to avoid any production cuts and thus keep prices lower for

longer as a way to weed out marginal producers and high-cost marginal new projects. Less production, less capacity

and thus greater prices over time will eventually compensate Saudi Arabia for the short-run costs of lower prices. In

this sense, it could be behaving like a “predatory” oligopolist, using pricing power to destroy its competition. Note

that there is an economic as well as a political motive for this behavior. Global supply growth is too high given

lackluster demand expansion. Prices need to fall to deal with the over-supply. OPEC output is relatively low cost, so

it does not make sense for OPEC countries to provide the marginal barrel.

On the other hand, it is also possible that Saudi Arabia is only temporarily avoiding production cuts as a way to corral

the free riders in OPEC (other Gulf States) or even producers outside OPEC (such as Russia). Once it can credibly

ensure that massive free riding will not occur, Saudi Arabia may be more likely to accept the production cuts

necessary for a rapid recovery of prices in 2015. Which strategy Saudi Arabia will follow is not yet clear, and may

depend on how low prices fall in the near term.

The oil price slump is a clear net positive for the global economy (leading to higher growth and lower inflation) as it

is more of a positive supply shock rather than one just driven by weak demand; but oil exporters and producers will

lose even as oil importers and consumers win. EMs’ high energy intensity means the price slump will benefit EM

consumers more than DM ones. In particular, India, South Korea, Turkey, Taiwan, China (to a lesser extent) and other

inefficient oil importers will all benefit greatly.

Oil prices will remain under pressure in H1 testing new cyclical lows, but may stabilize above $80 by end-2015 on

eventual production and capacity cuts once Saudi Arabia has achieved its economic and political goals. Oil-exporting

countries that allow FX adjustment (such as Russia and Mexico) will see their trade balances worsen by less than the

dollar-peggers in the Gulf.

Other commodity prices will remain soft—especially industrial metals, such as copper, iron ore—given weaker

demand from China and other EMs, the stronger dollar and the Fed’s exit from ZIRP. Gold prices may fall to $1,050

an ounce or even below as the capacity of gold to hedge against geopolitical and financial upheaval is reduced by

the lack of severe tail risks.

Risks to Our View

Oil prices might fall to $60 or below as market sentiment plunges, absent a clear price signal from OPEC.

Alternatively, Saudi Arabia might agree to sharply curtail OPEC production (as longs as other oil producers credibly

commit to also cut and not free ride) once it has achieved its economic and political goals, thus pushing oil closer to

$90 by end-2015.

DM Inflation: Still No Bark as Disinflation Reigns

Low core inflation will continue to plague inflation-targeting DM central banks given slack capacity in goods markets,

slack labor markets, high real exchange rates and weakening inflation expectations (see our recent study), and

BIG PICTURE





11

Page | 11

headline inflation may fall even more than core as oil and energy prices are plunging. China’s weakness will lead to

more disinflation as commodity prices fall, RMB possibly depreciates relative to the U.S. dollar and China’s excess

supply of industrial goods is dumped on global markets. The stronger growth in the U.S. and UK will not necessarily

lead to a faster pick-up in wages and inflation as the slack in the two economies’ labor markets is still large, the non-

accelerating inflation rate of unemployment (NAIRU) is probably lower than previously estimated, and trade unions

and labor are weak (as capital-intensive and labor-saving technological innovations, trade and globalization lead to

a rise in inequality and a reduction in the share of labor income in GDP in DMs).

This low headline and core inflation gives DM central banks leeway to delay rate increases (for example, the Fed,

BoE, BoC and RBA) or ease further (the ECB, BoJ, SNB and Riksbank). But inflation is not dead, nor is deflation likely

to be a global phenomenon, as we have recently explained. Moreover, the EMs with low inflation can ease more,

especially oil-importing economies. High-inflation “fragile” EMs will experience a faster fall in their headline inflation,

which will also allow some monetary easing. But oil exporters with negative terms-of-trade shocks may experience

further inflationary currency depreciation.

Regarding the implications for the markets, lower inflation and the suppressed term premium will keep 10-year bond

yields below the nominal GDP outlook; and long rates in the U.S. and UK will rise only slowly (50 bps max in 2015),

and remain below 1% in the EZ and Japan. In an environment of low inflation but no outright deflation, the main

drivers for equity returns will remain growth expectations and the related uncertainty. With global growth marginally

improving and valuations in countries with better prospects already stretched, global equity will yield single-digit

returns, with a rising numbers of drawdowns.

Risks to Our View

The main risks to our baseline are that long yields in the U.S. rise by more than we expect (3.0-3.5%) as better growth

and higher inflation lead to the Fed exiting earlier and faster from ZIRP. Conversely, U.S. long yields could struggle

to get above 2.7% if U.S. growth surprises to the downside, the dollar becomes too strong, lower actual and expected

inflation sets in and the Fed delays its exit to Q4 2015 or even Q1 2016.

Monetary Policy Divergence in G4, but Still Dovish Overall, With Currency Wars by Proxy

Divergence in growth and inflation rates between the U.S. and UK on the one hand and the EZ and Japan on the

other has led to divergent monetary policy paths. The Fed and BoE will start normalizing their policy rates in late

2015, while the BoJ will continue to top-up QQE and the ECB will move—belatedly—to formal sovereign bonds

purchases next year. This policy divergence will keep the euro and yen under pressure, which will end-2015 at $1.15

and ¥128, respectively. In our forthcoming Q1 Global Outlook, we highlight a new theme that could play out over

our forecast period: An opening up of a gap between the Fed and the BoE (the two most advanced central banks),

as the UK feels the adverse impact of low EZ growth and inflation more than the U.S., forcing it to postpone its first

hike into 2016.

But the BoJ’s decision to top up its QQE together with the Government Pension Investment Fund’s plans to purchase

more foreign assets (a backdoor form of FX intervention) led to a new round of “competitive QE” that will eventually

also affect the Fed and BoE. So-called currency wars—via proxy QE or conventional monetary easing wars—are likely

to continue as most DMs (given weak domestic demand during unfinished deleveraging cycles) will try to boost

growth via net exports, requiring weaker currencies and, thus, additional monetary easing. The recent BoJ actions

and consequent weaker yen are triggering reactive easing in Asia (China, Taiwan and South Korea, for example), and

will eventually do so all over Europe. The ECB is moving toward QE, Switzerland is aggressively defending its currency

BIG PICTURE





12

Page | 12

floor, Sweden, Norway and parts of central Europe may ease more and, in some cases, even move to currency targets

to avoid importing deflation.

Eventually, all this monetary easing pressure will result in a stronger dollar (which is also rising against commodity

currencies and fragile EM currencies), and may persuade the Fed to exit later and more slowly to avoid importing

weaker growth and deflation into the U.S. from the rest of the world. Unlike real wars, currency wars cause no

damage and, in a world with deflationary threats caused by insufficient demand, are actually a good thing: They are

really just “uncoordinated monetary easing.”

Indeed, although currency wars are zero-sum games for currencies and trade balances (a weaker currency/trade

balance for one country means a stronger currency/trade balance for another), generalized monetary easing in the

pursuit of a weaker currency still has net positive effects on growth and inflation, as it boosts asset inflation for a

wide range of risky assets, increases expected inflation and keeps real borrowing costs for the private and public

sectors lower than they would otherwise be. The risk is that currency wars might eventually lead to trade wars: For

example, a protectionist backlash against free trade via delays to TPP and TTIP, and perhaps resulting in other

bilateral restrictions on trade.

Risks to Our View

Growth in the U.S. and UK could surprise to the downside if global growth is weaker than we expect and the dollar

and pound strengthen by more. Japan and the EZ could surprise on the upside if easier policy-driven financial

conditions are surprisingly successful at boosting demand. If that were to happen, the U.S. dollar rally could fizzle

out and even reverse.

Fed Exits—but Not as Early or Fast as Most Expected

The U.S. will grow above potential in 2015, supported by lower oil and commodity prices, an improving labor market,

the shale revolution, the more advanced stage of private deleveraging, less fiscal drag and some re-shoring of

energy- and capital-intensive manufacturing.

The Fed is thus rightly done with QE but, now, the question is: When will it exit ZIRP and how fast? In our baseline

scenario, “lift-off” occurs in Q3 rather than earlier, for a number of reasons: Headline inflation is falling, given lower

oil prices, and even core inflation is low; expected inflation is low and falling; wage growth is still anemic, while unit

labor costs are rising slowly, there is plenty of slack—if shrinking—in the labor market; the dollar is getting stronger;

and global growth is weak. Moreover, the Fed does not want to risk an aborted lift-off, which other DM central banks

have experienced. There is thus an option value of waiting a little longer, especially given inflation is low.

The labor market still has meaningful if reduced slack; thus, wage growth pass-through to core inflation remains

weak due to the persistent real wages-productivity gap. And while unemployment has fallen close to historical

measures of NAIRU, the U6 definition, which includes marginally attached and part-time workers, remains much

more elevated than at times of previous policy-rate “lift-offs.” The Fed is also increasingly struggling to buoy inflation

expectations as the five-year/five-year measures are heading south.

Still, the economy will be closer to NAIRU by Q3 and, as there are lags between the labor-market tightness and any

acceleration in wages, and between rate hikes and their impact on inflation (given monetary policy itself lags), we

think it makes sense for the Fed to start exiting ZIRP in Q3, rather than waiting even longer. Moreover, considerations

of financial stability may also persuade the Fed to start hiking sooner (by Q3, in our view), even if labor slack and

inflation suggest waiting slightly longer. Indeed, it is not clear that counter-cyclical macropru policies will be effective

BIG PICTURE





13

Page | 13

in controlling the rising frothiness in financial markets. Thus, the Fed may be forced to hike slightly sooner—if only

gradually—to try to control the nascent risky credit and asset bubbles.

The Fed could also hike sooner and faster if global factors keep long-term interest rates too low in the U.S., feeding

excessively easy financial conditions. Then, a rise in policy rates would compensate for too-low long rates to prevent

financial frothiness and a possible and risky real economic overheating caused by asset and credit bubbles.

Risks to Our View

There are two main risks to this central scenario. First, the Fed could exit faster if growth remains strong, the labor

market tightens faster than we expect and inflation picks up sooner than under our baseline. But this looks to us like

an increasingly low-probability scenario. Second, the Fed could stay on hold through Q4 or even until Q1 2016 if

global growth and dollar strength starts to take a meaningful bite out of U.S. growth.

Some EMs Find Space to Ease/Slow Tightening and Allow FX Weakness, but Others Face Strong Headwinds

EM are a very differentiated group. The better performers will be those that implement macro adjustments and

structural reforms and have closer trade links to the U.S. than to China, while being energy and commodity

importers. The poorer performers will make less effective or few macro and structural adjustments, and will be

energy and commodity exporters and trade partners of China rather than of the U.S.

The stronger U.S. growth will benefit a few of its neighbors and close trade partners (for example, Mexico, Canada,

UK, Colombia, Korea and other NICs), as well as EMs that are more aggressive on the reform front, such as India,

Mexico and maybe Indonesia. Some 2014 EM laggards, such as Russia, South Africa, Brazil and Thailand, may record

very modest improvements in their anemic growth rates, but we do not expect major structural reforms.

The China slowdown will hurt all commodity exporters—not only the fragile ones, such as South Africa and Brazil,

but also some with stronger fundamentals, such as Chile, Peru, Hong Kong, Malaysia and Singapore.

The fall in oil prices, meanwhile, benefits the oil importers (China, India, Turkey and Taiwan, for example) and hurts

the oil exporters (Russia, Nigeria, Venezuela, Kazakhstan, Iraq and the Gulf States). We see FX weakening and

external debt spreads widening in the first group, and assume the GCC states will use their ample reserves to

maintain their dollar pegs. The avoidance of FX adjustment in the short term comes with the risk of disinflation,

which may exacerbate local asset-price corrections. In the longer term, we see the willingness of Russia to allow the

ruble to depreciate as positive, assuming the authorities can keep interest rates high enough to stop a flood of local

deposits out of Russian banks. We will watch the sizeable corporate repayments due in December and February

closely for rising financial-stability vulnerabilities. Mexico and Colombia’s willingness to let their currencies

depreciate is a sign of the credibility of their central banks and the economies’ ability to adjust to the external shock.

The so-called fragile five—India, Indonesia, Brazil, Turkey, South Africa—have all meaningfully tightened their

monetary policy, which has slowed growth in 2014, although their currencies have been allowed some downward

adjustment. Thus, they are now less at risk of the Fed’s coming tightening. Those EMs most exposed to the Fed’s exit

are those with lower inflation, low policy rates and current account deficits (Peru, Chile and even Mexico) or housing

bubbles (Hong Kong and Singapore).

But the fragile five’s fiscal adjustment is still too slow relative to what is necessary. The external balance

improvement has been modest, apart from that driven by lower oil prices (for the commodity importers). More

importantly, there have been few moves toward structural reforms. Fragile-five governments and central banks have

BIG PICTURE





14

Page | 14

taken some decent monetary and even fiscal decisions (such as cuts to subsidies), but structural measures have been

few and far between, most notably in India. Even Indonesia’s promising new government has maintained a

protectionist tilt, while reforms in Turkey are completely off the table until after next year’s general election.

Some EMs are facing sovereign credit risks, which keeps us negative on external debt: Argentina was forced to

default given the obstruction from the U.S. courts, but it will likely remedy its default in 2015. Although we believe

the pieces are falling into place for a deal with the “holdout" creditors, Argentina’s short-term macro policy is

deteriorating.

Ukraine, meanwhile, needs an orderly debt restructuring that has been delayed only because the official sector (the

IMF, U.S. and EU) are still keeping their heads in the sand for political reasons and do not want to recognize the

obvious: That Ukraine’s debt is unsustainable. Most of Ukraine’s banks are also insolvent and need to be recapped

or resolved. Regardless, the local currency will likely face further adjustment as the Russian ruble devalues.

Venezuela is desperately trying to avoid default by raising dollar liquidity to pay its massive foreign currency debt

payments. But, if oil prices stay at the current low levels, a credit event becomes more likely. And several small

Caribbean countries have low growth and unsustainable debt ratios. This is also starting to become a risk for some

African countries that have over-borrowed in the past decade, for example, Ghana. The IMF program in Serbia, and

talks toward programs in Ghana and Zambia, should provide some cover for those troubled economies.

In this context, EM central banks will do less tightening due to the weak oil prices and dovish Fed, together with

peaking inflation; some, such as India and Poland, may even be able to cut rates. Asian EMs with low and falling

inflation that are exposed to the BoJ will ease further (for example, South Korea, Taiwan and Singapore, while

Indonesia will hike less than markets assume).The same goes for those EMs in Europe that are affected by the coming

ECB QE move: They will keep policy rates on hold for a lengthy period of time (for example, Poland and Hungary)

and some will weaken their currencies (the Czech Republic and Israel). Hungary will stay on hold, offsetting the

lingering vulnerabilities of the economy with the highest external and government debt in the EM Europe region.

Fed tightening, when it occurs, will also affect bond rates. A number of Asian local currency five-year forward five-

year rates look very low in comparison with U.S. rates (for example, South Korea, Taiwan and Hong Kong). With the

dollar and U.S. economy strengthening, rate spreads vis-à-vis the U.S. are likely to shift from negative to positive.

India, Mexico and other parts of Southeast Asia will implement some structural reforms, and experience a flattening

of their yield curves as a result, thus underpinning our preference for local debt over external. We also like Korean

and Polish equity: They are exposed to U.S. demand and decent local demand, respectively, and have cheap

valuations. External debt yields, meanwhile, do not compensate for the risks (especially in Brazil and South Africa,

where fiscal policy is so focused on avoiding rating downgrades that it will weigh on growth rates).

Currencies may need to move further downward in twin deficit economies that have not made enough macro and

fiscal adjustments (South Africa), in oil and commodity exporters with flexible exchange rates (Russia and Colombia)

and in those EMs with low policy rates that are under pressure from the Fed’s exit and more aggressive easing from

the BoJ and the ECB.

The fall in commodity prices, currency weakness and ensuing economic weakness in some commodity-exporting

EMs could seriously strain some EM corporate and financial institution balance sheets, with stress seen not only in

equities but also credit. A shakeout of the mining sector is likely globally, with many smaller players not surviving,

especially in sectors where size and large investments are the key to survival. Some corporate and financial

BIG PICTURE





15

Page | 15

institutions with significant foreign currency liabilities will face large balance-sheet effects from weakening

currencies and will require either domestic bailouts or debt restructurings.

Political risks in EMs are likely to continue in Russia and Ukraine, Hong Kong, Argentina and especially Venezuela.

Risks to Our View

Given the weak political economies of some EMs, reversals of fiscal and monetary adjustment may occur together

with underperformance on structural reforms and further lurches toward state capitalism. Then, too much micro-

managing and deep cuts to public investment, in the context of weak fiscal outlooks and a less supportive external

environment, would threaten credit ratings. But if the EZ, Japanese and Chinese growth were to surprise to the

upside or domestically driven EMs implement more reforms to attract long-term capital and meet their long-term

needs, a number of the more fragile EMs will do better than under our baseline.

Bubbles in Risk Markets (From Housing, to Credit, to Equity), With Macropru Nearly Toothless

Conventional and unconventional monetary easing has mostly not led to rapid credit creation in the private non-

financial sector. Rather, it has led to asset reflation, as one of the implicit goals of central banks has been to drive up

risky-asset prices (equities and housing, for example) to boost private spending via positive wealth effects. Asset

reflation in fixed-income and credit markets also leads to positive wealth effects, as well as a reduction in borrowing

costs for private and public agents, thus reducing their debt burdens and boosting their spending.

It is always hard to tell when asset reflation is fundamentally driven—as easy money restores growth and the income

from risky assets, such as profits—and when the boost from easy liquidity has created “irrational” frothiness and

even outright bubbles. These asset bubbles can also be fueled by credit bubbles. Indeed, we can now see the start

of the re-leveraging of private-sector agents in some DMs (shadow banks, corporates and even parts of the

household and financial sectors), as well as public-sector entities. In the credit space, junk bond issuance is back to

2007 levels, and with looser underwriting standards (covenant-lite clauses and payment-in-kind toggles are in

vogue). Similar frothiness is seen in leveraged loan and CLO markets. The embedded leverage in some of these

instruments and other derivatives is significant. Roubini research shows that housing frothiness is spreading in a

dozen DMs and EMs. And in the U.S. equity market, P/E ratios are now above historical averages, Shiller’s CAPE is

well above its historical average, the ex-ante equity risk premium is below average and certain sectors—tech, social

media, bio-tech—are starting to bubble, and have even started to correct this year.

The key issue is not whether there is an asset and credit bubble now in many markets, as we are only in the first few

innings of the credit cycle. (For comparison, HY spreads of 450 bps are nearly double the lows during the credit

bubble in 2007, while trailing P/E for the S&P 500 was over 30 during the dotcom boom.) The issue is whether the

Fed’s slow exit from unconventional and conventional monetary policies (and that of other central banks) will feed

the frothiness until it turns into outright bubbles, say in the next two years.

Policy makers respond that they have two goals, economic recovery/stability and financial stability, and that they

also have two separate instruments—monetary policy for the first goal and macropru regulation for the second. But

this may prove wrong-headed. If macropru is tried and fails, and there are many reasons why it may prove

ineffective, then central banks will be damned if they do and damned if they don’t. If they exit unconventional and

conventional easing slowly, as low growth, high unemployment and low inflation justify, they risk feeding the mother

of all bubbles. If at some point they try to prick that bubble with monetary policy, then they could spark a bond and

BIG PICTURE





16

Page | 16

credit market, in turn leading to an economic hard landing. This is not a short-term risk but, over the next two years,

the risks rise significantly of financial frothiness eventually leading to a “Minsky Moment.”

This trade-off, rather than the exact date of the first rate hike, is the key dilemma the Fed and other major central

banks (the BoC, the BoE, the SNB, the Riksbank, Norges Bank, the ECB, the Hong Kong Monetary Authority, the

Monetary Authority of Singapore, the People’s Bank of China and others) will face in the next two years.

If macropru fails or seems likely to be ineffective, some central banks—starting with the Fed—may start tightening

monetary policy sooner and faster than the economic fundamentals justify to signal concern about containing

financial-stability risks. But this rate hiking should remain moderate to avoid the risk of killing the recovery or causing

a sharp correction to bond and credit markets.

Risks to Our View

Of course, we may be too pessimistic on the inability of macropru policies to contain asset and credit bubbles. In

addition to counter-cyclical macropru, the walls of capital, liquidity and lower leverage that the post-global financial

crisis reforms have created may have made the regulated financial system more resilient to systemic shock, and with

much greater loss-absorbing capacity. Thus, macropru might gradually work and eventually enable policy makers to

move on to tighter monetary policy, once recoveries are more robust and economies can cope with rate hikes that

are in part aimed at controlling asset and credit bubbles.

Low Volatility, Low Returns and Suppressed Business Cycle Will Give Way to Bouts of Volatility

DM central bank policies will continue to pump liquidity into markets; this suppresses volatility, extends valuation

multiples (which means lower future returns) and prevents growth surprises from leading to market corrections, say

in equities. Thus, ex ante, volatility is likely to remain near historical lows in DM equities (although higher than this

year’s average as the U.S. business cycle matures), even if it will not be so low for rates and, especially, FX. Given

that valuations are stretched for many assets (such as equities, credit and fixed income), absolute returns will overall

be lower than in previous years.

With global growth marginally improving relative to 2014 and monetary policies remaining relatively accommodative

in the G4, 2015 will be another year of positive returns for U.S. and global equities, even if returns are likely to be

single rather than double digit. The U.S. is growing above potential and will power global equity performance. But

since valuations in the U.S. are starting to look stretched and the Fed will start exiting ZIRP in H2, the upside for U.S.

equities is limited and shocks could lead to temporary corrections.

Meanwhile, Japanese stocks are likely to outperform as they have been pumped up with more monetary stimulus,

delayed fiscal austerity and government purchases of equities. EZ equities are no longer attractive overall, although

German and Spanish equities will see better results, while UK equity is likely to be undermined by election jitters,

regulations, and the economy’s exposure to global risks.

EM equities will also provide positive returns, but with significant differentiation: Oil importers will outperform

relative to oil exporters; China and countries in the Chinese supply chain may suffer from a slowdown in China that

is greater than consensus expects. Economies geared to the U.S. recovery and those making macro adjustments and

implementing structural reforms will outperform those with worse policies and stronger links to China.

BIG PICTURE





17

Page | 17

Given the likely volatility of currencies and likely strength of the U.S. dollar, local currency returns in equity markets

will be higher than in dollar terms. So, currency exposure should be hedged to avoid lower returns via currency

movements.

Volatility spikes are likely to be short-lived, but could be violent due to the high volatility of volatility when negative

growth or geopolitical surprises occur and policy makers show inertia in responding to such shocks. Indeed, the

volatility and market-correction episode in 2014 in the late summer and early fall was the result of a series of

negative growth surprises and scares, followed by monetary and fiscal policy inertia. Markets rebounded when the

Fed, the BoJ, the ECB and other central banks finally started to provide dovish signals, and governments reversed

fiscal policy mistakes in Japan or modestly diminished them in the EZ, reducing fiscal drag.

In the credit space, HY credit is attractive with U.S. recession risk low and given the slow Fed exit. The search for

yield and a benign rate environment and low default risk will enable HY, where spreads average 450 bps, to

outperform Treasurys, but low liquidity means sharp sell-offs and ETF-driven volatility is now par for the course. IG

might outperform Treasurys, but is not attractive in risk-adjusted terms. Spreads are around fair value, but the pace

and quality of issuance suggests some frothiness and a risk of bubbles down the road that will eventually burst (more

likely in 2016 than 2015).

Risks to Our View

The main downside risk to this scenario of relative market moderation is bouts of market volatility and more

persistent market corrections as macro (Chinese and EZ data), policy and geopolitical surprises (for example,

worsening of tensions with Russia or political risks in the EZ) occur, while market liquidity structurally shrinks in credit

and fixed-income markets, as liquidity and capital regulations have led market makers in DMs and EMs to shrink

their inventories and activities over time. Also, as valuations are stretched in many markets, the downside risks may

be greater than the upside ones, especially if negative shocks materialize.

Contact the authors

The above content is offered for the exclusive use of RGE's clients. No forwarding, reprinting, republication or any other redistribution of this content is permissible

without expressed consent of Roubini Global Economics, LLC. All rights reserved. If you have received access to this content in error, RGE reserves the right to enforce

its copyright and pursue other redress. RGE is not a certified investment advisory service and aims to create an intellectual framework for informed financial decisions

by its clients. This content is for informational purposes only and does not constitute, and may not be relied on as, investment advice or a recommendation of any

investment or trading strategy. This information is intended for sophisticated professional investors who will exercise their own judgment and will independently

evaluate factors bearing on the suitability of any investment or trading strategy. Information and views, including any changes or updates, may be made available first

to certain RGE clients and others at RGE's discretion. Roubini Global Economics, LLC is not an investment adviser.

For questions about reprints or permission to excerpt or redistribute RGE content, or for a PDF version, clients should contact their RGE account representative.

rge the year ahead roubinis top 10 macro themes

Documents

global growth

ez growth

roubini global economics

growth improvement

global shocks

worlds key growth engine

roubini research team

nouriel roubini