Why to fear Brexit, inflation and an emerging market crisis

With less than a week of the new year marked off on the calendar, fears about China's slowdown are back, global sharemarkets are tanking and the two most powerful Islamic nations are at daggers drawn.

However, that's not all we have to worry about, investment bank Societe Generale says.

Markets are questioning China's growth model
Markets are questioning China's growth model Photo: AP

Its global head of economics, Michala Marcussen, has come up with three scenarios that could surprise pundits, sour sentiment more and further destabilise financial markets and global growth.

The first would be even lower than forecast growth in emerging markets and the spillover into developed economies.

As China's sharemarket has shown again on Monday, any surprises in the data of the world's biggest developing economy can trigger massive share sell-offs that then contaminate other global markets.

If these data shocks and market reaction reflect deeper problems in the Chinese economy, emerging markets and other commodity exporters that rely on Chinese demand may fare even worse than the gloomy outlook already painted. 

Latin America, for example, was expected to grow at 1.6 per cent this year when forecasters gathered a year ago. However, this has since been downgraded to just below zero.

Monetary tightening by the US Federal Reserve, which got under way just before Christmas, will only serve to exacerbate this as global investors continue to yank their money out of increasingly risky assets in developing economies.

Companies in those countries, particularly those with US dollar-denominated debt, are struggling.

The ensuing competitive currency devaluations – or currency wars – would help exporters offset weak demand, but pile pressure on companies with external liabilities.

"Several risks could cause a further downgrade of the 2016 outlook, but to our minds one of the key uncertainties is just how resilient emerging market corporate balance sheets will prove to weaker growth prospects, lower commodity prices, weaker domestic currencies and tighter Fed policy," Ms Marcussen writes.

"A severe financial crisis in emerging markets spilling over to global markets has the potential to drag the advanced economies back to the edge of recession, and, in some cases, beyond."

With much of their monetary policy arsenal exhausted, developed countries' governments may be forced to respond by spending beyond their means.

Even the European Union, where there are limits on government deficits, may relax its stance on spending.

"Already in 2015, we have observed some fiscal drift," Ms Marcussen says.

"Faced with new significant downside risks, we would expect Japan to deliver further fiscal easing.

"In the US, we would also expect to see fiscal easing, but only after the election.

"In Europe, aggressive fiscal easing would be politically more challenging, but with major elections looming in 2017, concerns over the wrath of the [European] Commission may be brushed aside in favour of fiscal easing," she says.

Second, inflation could catch the US by surprise, Societe Generale says, as the deflationary effects of cheap oil roll off and the country's drum-tight labour market squeezes up wages.

Again, this would be good news for the world's biggest economy, but the consequent hastening in Fed tightening might catch a lot of bond investors off guard.

"Our forecast is for US 'lowflation' to end in 2016," Ms Marcussen says.

"This will see the Fed tighten more aggressively than discounted by markets and surprise bond markets in a big way."

Finally, beware the "Brexit", or at least market sentiment leading up to and after a promised British referendum on the country's membership of the European Union, which could take place within six or seven months.

"To date, financial markets seem to have taken little notice of this event," Ms Marcussen writes.

"To our minds, there is a high risk that the UK could vote to leave the European Union – a risk we set at 45 per cent – with significant economic damages resulting from such a risk scenario.

"We estimate the cost at 0.5-1 percentage point per annum to UK gross domestic product over the decade that would follow.

"For the euro area, the damage would also be substantial, ranging from an annual output loss of 0.1-0.25 percentage points."

Happy New Year!