29 November 2017
This article is part of the UBS House View Year Ahead 2018, our yearly outlook on markets. You will find investment ideas and portfolio implications in the full report.
In our view, three risks are most prominent for investors in 2018.
1. Sharply higher inflation might force central banks to aggressively tighten policy
In our view, two circumstances could arise that might prompt central banks to act more boldly: a dramatic change in how members interpret economic data and an unexpected surge in inflation.
An abrupt change in philosophy seems unlikely. Key central bank personnel remain the same in most regions. In the US, the nomination of Jay Powell as the new Fed chairman suggests continuity, as Powell has served at the US central bank since 2012 and has supported the current set of policies.
When it comes to inflation, a sudden rise 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. At just 4.1%, US unemployment is close to a post 1970s low. Although wage growth remains subdued for now, a tipping point could occur if companies face such difficulty in hiring that they are forced to raise wages markedly to attract and retain staff, or if companies at full capacity are unable or unwilling to expand production and would raise prices in an attempt to contain demand.
Although an increase in inflation isn't necessarily a bad thing in itself, the Fed, should it become apparent that inflation is increasing too quickly, could be forced to raise interest rates rapidly to restrain demand. This would amplify the risk of recession – every US downturn in the past 45 years has been preceded by a steep Fed rate hike cycle.
2. Geopolitical shocks could emerge from North Korea's nuclear weapons testing or political instability in the Middle East
Although we consider a "first strike" unlikely, North Korea's nuclear tests raise the risk and consequences of miscalculation. For instance, test missiles could miss their intended neutral targets, or North Korea could miscalculate the location or intention of US warplanes, which regularly conduct exercises in the region. The potential threat to Japan and South Korea, the world's third and eleventh-largest economies, respectively, means any conflict, or fear thereof, could have global consequences.
Saudi Arabia is the world's largest oil exporter and swing producer, and controls most of its 2.5-3 million barrels a day of spare capacity. The recent increase in tensions between Saudi Arabia and Iran has raised the risk of a disruption to oil supplies. If proxy wars between the two countries upset energy exports, and if this coincided with renewed sanctions on Iranian energy exports, the oil price, we believe, could reach USD 80/bbl and stay there for three to six months.
3. China could mismanage its rising debt, leading to a greater-than-expected economic slowdown.
We see two potential ways in which markets could grow fearful of a debt crisis in China.
The first, and most likely of the two, in our view, is for one or more smaller-scale credit crunches to emerge at a regional or sector level. Some sectors have significant overcapacity issues, and several large Chinese companies in the insurance, real estate, and aviation sectors are already showing initial signs of credit problems. If clusters of credit defaults begin to form and fears of default arise in wealth management products, there would be concerns about contagion into the wider economy. In our view, should this happen, the Chinese government would likely have sufficient resources to prevent widespread contagion, but global financial market volatility could increase until the situation is contained.
The second potential route is if the government miscalculates and takes steps toward capital account liberalization, a move that could backfire and spark a renewed spell of capital outflows from the country. As in 2015, global concerns could arise about China running short of reserves and needing to significantly devalue its currency, which would potentially hurt companies that supply goods and commodities to the Chinese economy. Again, we believe that the Chinese government is likely to be able to contain this risk through targeted regulation, as it has before, but market concerns cannot be ruled out.