Potholes could make for a bumpy year

As we look forward into 2014, I see more "potholes" than "black holes". What I mean by "black holes" is that I cannot see anything presently that might blow up the markets, perhaps worryingly no one else can either. Policymakers and central banks have by-and-large put in place guidance and policies to mitigate many of the systemic risks out there over the last few years. But there are some potential potholes ahead such as those arising as governments try to cope with their fiscal responsibilities and those from the European periphery (Portugal and/or Greece), the Asset Quality Review, or the European parliamentary election in May.

While the strong Forward Guidance from the Fed, the Bank of England and the European Central Bank has led to a lessening of global uncertainty and reduced the volatility of asset prices for now, it has actually made the market less stable in the long-term as central bank interference decreases market resilience - the views of the central bank are reflected in the market, rather than the diversity of views of market participants - and by dampening volatility, and hence risk, it has built stresses elsewhere in the system.

While the US Federal Reserve is intent on tapering off its unprecedented quantitative easing, central bank balance sheets globally will continue to grow as quantitative easing is not going away. It is the rate of growth of the balance sheet that is being tapered. Markets have run a long way, however, the overall direction of markets is probably upwards, albeit at a more moderate pace than in 2013, as the taper is also a sign of confidence that the Fed believes the US economy has reached escape velocity and the financial system's stability has returned. Having said that, a pothole arising from general market complacency around the taper, or miscommunication on forward guidance or renewed concerns around the eurozone are all imaginable.

There are also potential risks for Asian and other developing economies as the Fed's taper takes hold. Remember when quantitative easing started there were massive capital inflows into Brazil, India and other developing countries. Conversely, it stands to reason that the magnitude and perhaps the velocity of these flows will change once the taper kicks in. While it is very difficult to be definitive and to quantify the actual currency flow mechanism, what is very clear is the US dollar's reserve status creates transmission risks globally, especially to developing markets.