Crisis Risks in 2016

In my January monthly, I highlight four themes that could feature in 2016:

The East-West Divide.  Last week provided us with a powerful reminder that uncertainty about the path of the Chinese currency can still cause meaningful global tremors. In contrast, in CFR’s recently released 2016 Preventive Priorities Survey, eight of the eleven most critical contingencies are related to events unfolding or ongoing in the Middle East. Whether the concern is Syria, rising tensions between Saudi Arabia and Iran, or a weakening of state control elsewhere in the region, it is hard to discount the Middle East as the leading source of risk to markets in 2016.

So, is there a disconnect between political risks and market expectations? For now, the answer seems to be no. With oil and other commodity prices at record lows, and with no evidence that Saudi Arabia or any other country has an incentive to cut production, the traditional channel through which Middle East turmoil infects markets—a spike in prices—seems disabled. That is not good for the major commodity producers, notably Russia, Brazil and Venezuela among emerging markets (and a reason some see Latin America as a major source of market risk this year), but it is good overall for global demand. That said, if anything happens that undermines this confidence in steady, lower oil prices, it is hard to imagine that markets will continue to believe in this version of rebalancing.

Preparing the Fire Department.  I am by no means the only person worried about whether policymakers are sufficiently prepared for a downturn in the global economy.  We are reaching a period where central banks can no longer be expected to be at the vanguard of demand support and crisis response. The Federal Reserve has begun a process of gradual normalization and questions are arising about the power of—and political will for—additional quantitative easing (QE) by the Bank of Japan and European Central Bank (ECB). This means that fiscal and structural policies need to play a greater role in the event of a new global shock. The good news is that U.S. and European fiscal policies have become slightly more stimulative after years of cuts; the bad news is that there seems to be little appetite for additional moves, removing a potential support for global growth in a downside scenario.

The broader challenge to our capacity to address another economic crisis is rising populism, which appears to be a brake on government’s ability to act in times of crisis, particularly in Europe. Divisions over migration, market reform, and further integration in the European Union already have been reflected in elections in Greece, Spain, and Portugal, and in 2016 the British vote on “Brexit” is likely to roil markets whatever the outcome. In European creditor countries, populism has been reflected in opposition to additional economic support to the periphery, increasing the risk that pan-European policies will be paralyzed in the face of a new crises in the periphery of Europe.

Corporate Debt Problems.  Work by the staffs of the International Monetary Fund (IMF) and Bank for International Settlements (BIS) in the past year has made a strong case for concern with high levels of corporate debt and leverage, particularly in commodity-based emerging markets facing rising interest rates, capital outflows, and reduced demand for their goods. Many of these corporations have explicit state support—state enterprise debt in emerging markets is estimated at $800 billion—or act as if they have implicit backing. At this stage of the cycle, credit problems are likely to intensify, which will raise pressure on governments (many of which have limited capacity to take on additional debt) to step in or let these firms fail. This is a delicate balancing act, one which could easily entangle sovereigns that get it wrong. Add in Venezuela, where default seems inevitable; Greece, where a faltering adjustment program (and unrealistic expectations about debt relief) are likely to trigger renewed “Grexit” debate; and a growing debt crisis in Puerto Rico, and debt looks likely to be a dominant story for 2016.

The Dollar Cycle. Any further strengthening of the dollar is a threat to above-trend growth forecasts in the United States, though there is a natural stabilizer in place, as a strong dollar will be seen as a reason for a more gradual path of rate hikes from the Fed. At the same time, the relationship between a strong dollar and trade could become a political headwind, with renewed efforts by the U.S. Congress to punish perceived manipulators. This effort would be more likely to punish countries currently intervening to resist depreciation, such as Korea, than countries such as China that have traditionally been targets but are now depreciating.

In sum, 2016 looks set to be a volatile year in which geopolitics and hard-to-quantify policy dilemmas create significant uncertainty in markets. Policymakers will be asked to make tough decisions about where and when to intervene in markets at a time when their capacity to deal with crisis is increasing challenged, suggesting the road ahead could continue to be bumpy.