December is usually the month when market prognosticators wax eloquent on the year ahead. It is perhaps an ironic tradition in the inherently unpredictable financial markets.

However, there is a genuine need for future market outlooks despite forecasters’ patchy records and J.K. Galbraith’s dictum about two kinds of forecasters—those who don’t know and those who don’t know that they don’t know. Playing the market requires a view on what the future holds otherwise you may as well go to the nearest casino and bet it all on black. This is not very different from the budgeting and forecasting needs of firms in the real economy. For example, just as a miner needs to estimate returns from investment before starting to dig a big pit in the ground, an investor needs to estimate how the economy will perform before buying a consumer durables stock. The key difference is the larger number of unknowns in financial markets that lead to greater unpredictability in terms of outcomes compared with a firm’s budget. Therefore, financial market forecasts need to focus on broad trends rather than precise targets such as “stocks are likely to go up 20-25% in 2015". Those who aim at precision, usually achieve it by being precisely wrong.

To be of use, a financial market forecast needs to have two key elements, which give an idea of investing upside and downside. First, it must use a logical framework to describe the path to a future state of the world and second, it should consider alternative scenarios to the predicted state. The latter requires fundamentally altering the assumptions and not just flexing the variables (e.g. assuming a recessionary environment rather than merely reducing growth rate). This is crucial not only in assessing the impact of being wrong but also understanding early warning signs, which indicate that the market is taking a path different from the one predicted.

Keeping this in mind, how should we set about making our predictions for 2015?

All analyses must begin from the Fed and central banks of other developed markets, given that most asset prices globally are underpinned by the extraordinary monetary policy being pursued since the financial crisis of 2007-08. Active monetary tightening is a long way off even though the Federal Reserve’s exit from quantitative easing (QE) has tempered the amount of vodka in markets’ punchbowl (see Contemplating the Minsky moment). Although the European Central Bank (ECB) is expected to step into this breach left by the Fed’s exit, intense German opposition makes QE unlikely without re-emergence of the European crisis. This would offset any positive impact of QE on risk assets. Moreover, ECB’s efforts are likely to be delayed and inadequate given the compromises that would be required to get around Article 123 of the Lisbon Treaty, which prohibits it from directly buying sovereign debt (secondary market purchases are possible, as done via ECB’s SMP programme in 2012). Therefore, the thrust on global asset prices from loose monetary policy is likely to dissipate in 2015. This implies that valuations will assume greater importance and frothy parts of the market such as tech stocks and high-yield bonds are going to continue to lose air. In addition, the US dollar will continue to benefit from a tailwind as the Fed policy diverges from other developed market central banks.

While a stronger dollar can lead to emerging market wobbles (remember the taper tantrum of 2013?) as the BIS has warned, the collapse in oil prices provides a countervailing force. It benefits almost everybody barring the economies dependent on oil production (chiefly the Opec nations and Russia). Lower oil prices reduce inflationary pressures and current account deficits allowing emerging market central banks greater freedom to stimulate domestic economies. Moreover, oil is likely to continue to be relatively cheap in 2015 given the moribund global economic recovery (average global growth rate has been almost one percentage point slower in 2011-14 compared with 2004-07 when oil prices went from roughly $40 per barrel to more than $100 per barrel) and slowing Chinese growth. This would keep local currency bond prices supported in most emerging markets. A case in point is India where the Reserve Bank (RBI) has already hinted at a rate cut in early 2015. The outlook for emerging market foreign currency bonds and domestic equity markets is not as clear cut. Given the extent of international yield seeking, hot money flows that have entered these markets, they remain at the mercy of the global “risk on"/“risk off" trade.

Geopolitics and China are the two major factors that are likely to determine broad “risk on"/“risk off" in 2015. The Middle East remains explosive and the West’s stand-off with Russia also continues. While the Middle East may remain a chronic problem, the Russian situation has the potential to get worse as both sides dig in.

Moreover, the Chinese economy is visibly slowing with Q3 growth of 7.3% being below the stated annual target of 7.5%. The impact has already been felt in commodities with iron ore, coal and copper all making multi-year lows this year. A more significant correction looks increasingly likely to come sooner rather than later in China’s credit-fuelled, investment-led growth as authorities seek to rebalance the economy. Unless the government loses its nerve (like in 2009) and provides a large stimulus, a Chinese correction is going to dampen global investor sentiment. Therefore, on balance, “risk off" is likely to prevail and asset prices are going to correct. Together with falling inflationary pressures, this implies that safe haven assets in developed markets are likely to be in demand.

The above factors paint a broad picture for 2015 and rest on two critical assumptions. First, global growth will remain subdued and, second, central banks will not revert to aggressive easing. Both alternative scenarios—higher growth with delayed central bank tightening (as per norm) and resumption of QE/aggressive easing will restart the broad rally we have seen over the last few years and which seems to be juddering to a halt as we come to the end of 2014. However, for the bearish investor who believes in the central thesis, it is easy to spot these alternatives unfolding and correct his course appropriately. An essential requirement of following predictions is to always stick to Keynes’ philosophy—when the facts change, one should change one’s mind.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy.

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