What’s the worst that can happen? – Dr Pepper’s Guide to 2010

We are great fans of Dr Pepper here at the Ignis Rates team (the non-traditional variety), but in the spirit of its most famous advertising slogan we have looked at the key risks for 2010. From our own perspective the biggest risk is that the global economy gains sufficient momentum from the record expansion of liquidity as well as monetary and fiscal policy and smoothly transcends the eventual tightening of monetary and fiscal policy as well as withdrawal of liquidity to post strong growth over the next few years.

Strong growth is already priced into many risk markets and they are vulnerable to disappointment. These risks are examples of what Donald Rumsfeld would call known, unknowns. Another is the outcome of the UK general election. Here there is a 50% chance of a hung parliament, but even in this event the rating agencies would give the new coalition at least a month to agree upon sufficient fiscal measures to retain the country’s triple AAA rating.  However, there is about 20% probability that this coalition leans to the left and decides that ratings are for bankers and refuses substantial cuts in fiscal expenditure thereby precipitating a sterling crisis.

These known, unknowns concern investors, but it is the unknown, unknowns that keep Dr Pepper awake at night. In particular, geopolitical risks that have low probability but high impact are poorly discounted by financial markets. The largest geopolitical risks concern Iran and China.  The Iranian risk reflects the uncertain outcome of the current insurgency and Israel’s concerns over the regime’s nuclear ambitions.  We do not expect the Israeli’s to take unilateral action during 2010, but it is clearly a risk, whose impact will depend on the breadth of the attack and the resulting disruption to oil supplies. Another unknown, unknown is provided by protectionism.  Protectionism is economically counter productive. Politicians in the thirties knew this as well, but it didn’t stop those politicians making mistakes in defence of national interests.  Asia’s mercantilist currency policies subsidise exports and distort competition. China has reacted angrily to this criticism, but its growing inflationary threat is likely to allow a modest appreciation of the Renminbi in the second half of the year, which we believe will be sufficient to dilute protectionist sentiment until the terrible teens begin in earnest, but Dr Pepper is concerned about history repeating itself and America threatening to impose a 10% tariff on Chinese manufacturing imports.

For further discussion click here