Tuesday, December 21, 2010

Tail risk increasing in 2011

Our base case scenario for the new year calls for rising equity and commodity markets, lower dollar and increasing inflation concerns, but with tail risk from extremes which range from deflation and recession to inflation and more growth there can be a extremes in 2011.

  • Obama stimulus II will provide more upside potential for growth. While temporary, the tax cuts will give an economic boost that was not expected even in November. The effect will be more upside for stocks and the potential for rising rates.
  • The continued flood of liquidity from the Fed will place upward pressure on inflation expectations and downward pressure on the dollar.
  • Demand for dollars in the short-run will allow the current dollar rally to continue.
  • Continued strong growth around the world will allow for more upside potential in commodities. This is coupled with strong demand for real assets.
  • The downside will be still be marked by credit surprises. Spain and Portugal have been priced in the market, but the real risk will be in the municipal bond market in the US.
  • There is always fear from the unknown but surprises have more risk because of the continued fragile state of the government and consumer balance sheets.
The tail risk is still associated with fragile balance sheets in the US. This is an old story that will not go away.

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