The nature of the key risk factors has changed in a significant way. The main risk factors that threatened markets over the last 2-3 years have faded / been resolved / disappeared. Those risk factors shared a crucial feature, that their different resolution scenarios could and were imagined with some detail, and that their time-profile was mostly limited, they could not have lasted much longer than 1-2 years without resolution. The two key risk factors today have difficult to design alternative scenarios, and the likely duration cannot be expected to be less than 5 years.

The key risk factors of the last few years include the euro crisis, a couple of geopolitical events (i.e. Libya, Syria), the different political crises around US fiscal deadlines and debates, Fed tapering, and different moments of doubt about the Chines and US business cycles. Most people agree that last year’s end of the year rally had a lot to do with the reduction or elimination of the risk premia derived from these risk factors. Moreover, as those risks disappeared, the markets re-priced and then kind of stalled.

We argue that there are now two key risk factors in global macro, and they are different than the previous risk factors. These two are harder to track and analyze, and should take more than 1-2 years to resolve. One is the timing, pace and path of monetary policy normalization, mostly in the US by the Fed. The other one is the Chinese rebalancing, away from a capital intensive and export oriented growth at the expense of household income and consumption. The question is whether this means a serious change in market dynamics, the fact that the challenges ahead are so different in nature than in the past 2-3 years.

Monetary policy in G7 (especially the Fed) has broken new ground and taken the global economy to uncharted territory with its balance sheet expansion, stimulus and asset purchases. Tapering is just slowing the pace of buying, and when its idea was first floated it produced a non-trivial selloff in markets (May-June 2013). Now it is generally accepted that tapering is not the real thing, that it would still preserve the size of the Fed’s balance sheet. When and how that balance sheet would contract back to a more normal area is the question, and there lies the difficulty in thinking through scenarios. When you read or hear market observers talking about US monetary policy, everybody expects any change to be gradual, careful, and successful. There is one very bad reason for that consensus: anything else is too scary, difficult to think through, a nightmare nobody wants to live through. The Fed will soon be confronted with a mini taste of the problem, if US unemployment goes through the 6.5% threshold without the economy growing too fast. At that moment markets would wonder when and how policy rates would be increased, and what about the assets in the Fed’s balance sheet. This is already a topic of debate, and we should expect some change in tone and confirmation that only when growth and inflation increase further the Fed would act, but the episode would not be void of noise. Then, if inflation were to rise, there would be no room for rhetoric or debate, the Fed would have to increase rates and the unwind of liquidity would be expected to happen faster than anything that today’s markets price, which would produce a serious unraveling. Without getting into much detail or theory, it is clear that G7 monetary policy normalization is in the horizon, and that the smooth scenario without serious bumps is not necessarily the most likely scenario, but it is the consensus scenario.

China is another big unprecedented experiment that is reaching a moment of change. We have written many times about convergence, growth rates and the capital labor ratio. In summary, the now old strategy of growing through a capital intensive, high investment, export oriented model seems to have reached the limit of its abuse to household income and consumption (the ratio of household income or consumption to GDP has collapsed in the last decade, and is lower than most relevant comparison countries). The government seems focused on reversing that re-distribution of income away from households, and local dynamics naturally point in that direction (wage increases as a result of the first labor conflicts). For an economy the size of China, despite its central command nature, it is no simple task. Capital has been subsidized for decades, with whole industries and banking set up that way. Such a change is a massive endeavor, technically, politically, and economically. Growth is bound to fall further in the process, even assuming perfect planning and execution. Additionally, such rebalancing would reduce the current account surplus, which given its size is no simple shock to the world.

These are two important big picture phenomena that replace the plethora of short-term risk factors that had kept markets volatile in the pervious 2-3 years. These new risks might be too much of medium-term phenomena, and as such might not have the same effect on volatility. But through time benchmarks will be achieved, events will happen, and the effects could be significant. Soon we will elaborate on how these and valuation issues affect our asset allocation for 2014.