Stay on top of the risks

Market conditions never remain static, and because of the inherent uncertainties of macro forecasts such as this, there are several risk factors traders should monitor.

Hard-landing of the U.S. Economy. There are still a number of seasoned observers who argue the Fed is, in effect, asleep at the switch. The argument is that a sharp fall-off in economic activity ostensibly triggered by a bursting of the housing market bubble will lead to dramatic cut in U.S. interest rates.

A softish 2.0 to 2.5 percent Q1 2007 GDP seems largely baked into the cake. But if the slowdown appears to extend into Q2, the dollar could be weaker than anticipated here.

Enlargement or intensification of turmoil in Iraq. In discussions with clients, the expansion of the war in Iraq into a larger regional conflict that would include Iran has been a repeated theme. Such a development could be a potential shock for the global economy. Although most of U.S. oil and gas imports come from Canada, Mexico, and Venezuela, the potential disruption would likely increase the dollar’s downside risks.

Rise of protectionism. Rising protectionist sentiment has been kept in check, but weakened governments may have to accommodate that sentiment. Ironically, the rise of protectionism is occurring as the global economy moves into better balance: U.S. budget and trade deficits have been reduced, Europe and Asia are experiencing strong growth, and Asian currencies have appreciated and become somewhat more flexible.

Renewed appreciation of commodities. This may call into question — or even reverse — the easing of price pressures, fueling tighter monetary policy than discounted. The implications on the terms of trade for some countries, such as Australia, Canada, South Africa, Chile, and Brazil, for example, may be beneficial.

Capital controls. Thailand clumsily introduced capital controls in late 2006, only to incrementally introduce exceptions, and by early Q1 the strength of the baht had returned and the central bank was thought to be intervening again to slow the currency’s rise.

Other countries being deluged by foreign investors have few positive lessons to take from Thailand’s experience. Countries such as South Korea and China are liberalizing outgoing foreign-investment restrictions. Nevertheless the success of Malaysia’s experience from 1997 to 2005 with capital controls may encourage other countries to, when faced with such challenges, see the cost of capital controls as cheaper than the politically and economically viable alternatives.

Many consider Vietnam, whose stock market is up nearly 45 percent in the first half of Q1 alone (and more than 230 percent over the past 52 weeks through mid- ebruary), as a likely candidate for capital controls.