Weekly Risk Outlook

Weekly Risk Outlook
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Expected ECB QE programme will require some fine-tuning. Russia’s credit rating takes a hit as its economy weakens further. Iran may face new sets of US sanctions as newest round of talks begin, and Libya struggles to stave off classification as a failed state. All in this week’s GRI Weekly Risk Outlook.

ECB: the perils of the bank Draghing its feet

Following this month’s release of Eurostat data confirming that the Eurozone year-on-year inflation dropped to -0.2% in December 2014 (and amid forecasts that it will drop to -0.6% in January 2015), the economic bloc has decisively entered deflationary territory.

This has, in turn, prompted pressure on the European Central Bank (ECB) to stop dragging its feet and roll-out a much awaited sovereign Quantitative Easing (QE) program at the upcoming policy meeting on Thursday January 22nd. With the market shifting its approach to a theoretical QE program from “if” to “how”, all eyes are on ECB President Mario Draghi and whether he will effectively launch and provide the operational details.

While his prolonged rhetoric has been undermined by the specter of a Japanese-style deflation hitting the Eurozone, Mr. Draghi is expected to deliver on his loose promises that the ECB will effectively boost its balance sheet back to a target level of EUR 3 trillion.

If circumstances remain as they are now, the benchmark expectation is that the size of the QE programme puts initial investment levels at EUR 500 billion in the first year. However, to have a substantive effect on Eurozone inflation prospects, the consensus is this amount will not induce significant reflationary effects.

As a result, markets are expected to react positively so long as the sum of the program surpasses the benchmark quantity. However, unless an amount closer to EUR 1 trillion is announced, one can expect the euro to continue sliding for the coming months, with the expectation that a EUR 500 bn announcement could at least trigger a transient relief rally in the equities markets.

Finally, although the ruling of the European Court of Justice’s (ECJ) regarding the ECB’s Outright Monetary Transactions (OMT) program was favorable, the ECJ’s Advocate General’s decision is not binding. Moreover, given that the ECJ’s final ruling will not materialize before mid-2015, any prospects of a negative ruling would jeopardize the ECB’s ability to purchase sovereign bonds down the line.

If this was not enough, a potential win by a Syriza-led coalition following the early Greek elections of January 25th could seriously compromise a potential QE program announcement, just three days earlier. Given the ECB’s commitment to remain independent from politics, the proximity with the Hellenic elections may provide the ECB with a reasonable excuse to delay the launch of its QE program to March 2015.

Russia: on the verge of junk status

For the first time in over a decade, Russia faces the prospect of being deprived of its investment-grade credit rating. Facing the worst economic crisis since its 1998 default and burdened by the sanctions over Ukraine as well as tumbling oil prices, Russia’s creditworthiness is at risk of being categorized as junk.

Citing the country’s rapid deterioration of its monetary flexibility, the impact of a weakening economy on its financial system, and its draw-down on international reserves, Standard & Poor’s issued a warning last December. The rating agency went further to state that there was a 50% chance that Russia’s credit rating would decay to junk by mid-January 2015.

Similar concerns have been raised by Moody’s, which cut Moscow’s credit score to its second-lowest investment grade in October 2014 citing the speed at which capital flight is eroding its foreign-exchange reserves and borrower’s lack of access to credit as perilous developments for the economy.

In a scenario of oil averaging $60 per barrel this year, the Russian Central Bank has forecasted that GDP could contract as much as 4.7% in 2015 while expecting capital outflows to more than double, exerting significant downward pressure on a weakening rouble.

Even with negative press, a possible downgrade has been regarded by some investors as an opportune moment to purchase Russian sovereign bonds. Citing the low likelihood of default, many fund managers are viewing the downgrade as a perfect investment opportunity, as it offers high-yield bargains for funds that are not obliged to hold only investment-grade debt.

Nuclear talks with Iran: pressure amid looming new US sanctions

In the wake of what were supposed to be the final round of talks between Iran and the P5+1 last November, the five permanent members of the United Nations Security Council plus Germany are scheduled to engage in a new round of negotiations with Iran in Geneva on Monday, January 19th.

Marking the second round of talks regarding Iran’s nuclear program since the November 2013 interim deal, the lack of a binding deal by November 24th 2014 has extended the deadline for signing a “permanent settlement” by seven months, currently scheduled for June 30th 2015.

Although negotiations between lower-level diplomats and technical experts have been ongoing since early 2014, this meeting marks a potential watershed in what Germany’s Foreign Minister described as a “window of opportunity” for negotiations that can no longer afford to be extended endlessly.

This negativity comes in the wake of rumors regarding the possibility that Iran may have violated the terms of the interim deal by feeding uranium hexafluoride gas into a centrifuge of an enrichment facility at the Natanz nuclear site. Having committed to stop feeding any centrifuges as part of the agreement reached on November 24th, Iran and the P5+1 extended the deadline of the interim deal for another seven months, something that skeptics in Washington see as a sign of weakening leverage among the P5+1.

Such cynical responses have triggered reactionary attitudes by US lawmakers fearing that the Obama administration is giving Tehran too much leeway. Fearing losing his endeavor to secure a general rapprochement with Iran, the US President has been adamant towards the perspective of increasing the pressure on Tehran via further sanctions.

This has not resonated well especially among the Republican party. Given that the party now controls the Senate, Republican members of the upper chamber are reportedly to present a bill this week (ahead of President Obama’s State of the Union address on January 20th) that would trigger new sanctions on Iran – in the event that negotiations fail.

The response by both the Obama administration and the Iranian government has been one of strong opposition, arguing that this could be a potent cause for the talks to derail. While US Ambassador to the United Nations (UN), Samantha Power, has warned that new sanctions “could seriously undermine prospects for an agreement and end up isolating Washington instead of Tehran”, the spokeswoman for the Iranian government, Marzieh Afkham, has stated that the use of sanctions has already proven to be “ineffective and unhelpful”.

In spite of all the noise that the threat of new sanctions has created, it is clear that any bill presented to the US Congress will have to respect the terms of the Joint Plan of Action (JPOA) that frames the terms of the 2013 interim deal. To this end, no new sanctions would be imposed on Iran until the JPOA expires. As a result, there is much expectation, and indeed much pressure, for all parties to raise the prospects that negotiators will be able to agree on a framework for a permanent deal by March; so as to finalize it by the June 30th 2015 deadline.

Libya: frail efforts to re-launch peace talks

In the wake of months of fighting between rival militias, a fresh new round of peace talks was announced by the head of the UN Mission in Libya, Bernardino Leon, on January 14th. Unfortunately, this has done little to silence claims that the country is on the verge of total chaos and likely to become Africa’s next failed state, with the UN vainly attempting to reconcile warring parties through inclusive (but inconclusive) consultations.

Following two months talks with representatives of the two rival governments as well as representatives of some militias and municipalities, the prospects of reaching a political settlement regarding the formation of a unity government seem unlikely, particularly as some key political actors have not participated in the preparatory consultations.

With no functional national police or army, the prevailing security vacuum has tacitly permitted an array of armed groups to plunder the coastal oil facilities and damage important infrastructure in urban areas, prompting multinational oil companies to cut down on their operations. As the downward spiral continues to fall with oil revenues, Libya’s main source of revenue decays further, in turn encouraging an extent economic crisis to deepen further.

With the dire economics in mind, some militias have voiced their willingness to reach a political solution. However, until a credible ceasefire is announced, there is little hope for the sustainability of the peace talks.

Regardless these hindrances, the UN has announced that it will go forward with the first round of peace talks in Geneva, with the prospect of involving military actors in discussions under a conference setting this week.

The GRI Weekly Risk Outlook (WRO) provides analytical foresight on the economic consequences of upcoming political developments. Covering a number of future occurrences across the globe, the WRO presents a series of potential upside/downside risks, shedding light on how political decisions impact economic outcomes.

The WRO is put together by GRI analyst Jose Luengo-Cabrera

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