We know that economic risks are growing around the world, stemming from protectionist policies and a misunderstanding of why trade takes place. A resurgence in mercantilism with a move back to 1920s type solutions, means nationalistic and protectionist measures that have led to more poverty and greater instability.
We all know that the trade tensions are primarily the US versus a range of places as well as the EU and questions around why there is for instance a surplus of cars being exported from the EU to the US. There are a range of issues with other places as well such as Mexico and Canada, so it isn’t just the big blocks.
Another issue which has affected global trade is around the auto industry and the shift away from diesel to electric and the implications that this has in terms of the cleaner climate change rules which are triggering changes in the composition of the vehicle industry. This is predominantly affecting Germany and there are some issues around Argentina and Turkey.
There has been a bit of financial tightening that has occurred in the past few years at least in the US, with the modicum in the UK. But that has not been sufficient enough to lead to the slowdown that we have seen.
There hasn’t been a normalisation of monetary policy, and if anything, it is starting to be eased once again. The little that there has been was enough to create the conditions for a slow down, which doesn’t do well for the background economy and the financial markets profile.
"Although employment is rising at a higher pace, there has been a slow increase in real pay so that people don’t feel better off."
The upside is that with low growth comes low inflation, so policy can respond, and this will mitigate the downside. There has also been a huge increase in global employment.
The Economist showcased this in an article, which talked about the high level of global employment. Although employment is rising at a higher pace, there has been a slow increase in real pay so that people don’t feel better off. For those who have managed to get to higher paying jobs with higher productivity the conditions are much better.
The downside of trade is that there is an uneasy truce where conflicts could rear up at any point. This was demonstrated recently with the threat of increasing 5 per cent on tariffs with Mexico every quarter or year until the number of migrants coming from Mexico in the US diminishes.
There is a risk in Europe from banks who have bought too much sovereign debt, particularly from countries who are at risk of fiscal issues and struggles such as Italian and Portuguese debt. So some banks there are not properly capitalised.
You see this in the structure of the large holdings of Euros held in German banks by people from those countries – just in case they can’t get hold of their Euros in their own countries when they need to. This does imply concerns with the stability of the system.
"The downside of trade is that there is an uneasy
truce where conflicts could rear up at any point."
If things were normal, why then, 10 years after the crisis, do we have record low interest rates? In the 325-year history of the Bank of England, interest rates have only once been at 0.75 and that was post 2010.
Vast amounts of Quantitative Easing (QE), around £13trn, is still outstanding globally, predominantly in Europe, the US and Japan. If the bank bailouts and fiscal stimulus have worked then why is the economic recovery beginning to subside? Also, if conditions were back to normal then wouldn’t the financial market activity return to normal, i.e. wouldn’t they be free of this large amount of QE, which is buoying the liquidity in these markets?
I was at an event where there was a question around equity valuations; there isn’t a rational exuberance in markets and strong economic growth, so why should there be a sharp fall in equity prices.
"If the risks are high, why is volatility lower than average?"
However, suppose there was to be a sharp rise in interest rates or liquidity was withdrawn by central banks, we don’t know what would happen.
Global policy risks do remain high and the question is then if the risks are high, why is volatility lower than average.
If policy uncertainty is deemed to be high and geopolitical uncertainty is deemed to be higher than average, why shouldn’t volatility be higher? The reason is because there is plenty of liquidity around, which means that the signals about uncertainty aren’t getting through to asset prices.
This has been illustrated effectively by the measure of the Fair Value Index. The VIX index is based on the S&P 500 and policy uncertainty is captured in various implied commentary which is monitored on a regular basis. You can see the big dichotomy that there is between policy uncertainty and volatility.
In the last crisis, volatility was quite low and policy uncertainty was also low, so in a sense everyone was taken by surprise when there was a shock.
This time, volatility is low, meaning that markets are not priced for uncertainty, yet there seem to be high levels of uncertainty from the policy uncertainty measure. This means that this time the shock will be even greater because the markets are not being priced from this risk.
I would argue that the risk of a shock to financial markets is actually greater now than it was then. The financial market effect of something occurring which is not an unknown unknown but a known unknown, which no one is expecting, will be a surprise and volatility will have to spike higher.
In the context of global liquidity, if we look at money supply, this tells us that India and China’s money supply growth is still healthy at around 7 per cent, which means that their economies should continue to grow by around 5-7% depending on the links between the growth in money supply and the GDP. I believe that for India this implies a growth of around 7 per cent and for China 6 per cent.
"Growth in the US has slowed and peaked out a couple of years ago."
This also tells us that growth in the US has slowed and peaked out a couple of years ago and although there was this huge 1 trillion budgetary expansion with the tax cuts last year.
The effects of this are beginning to fade and US growth will slow towards sub 2 per cent this year and next after being +2 per cent over the past few years. European economic growth looks likely to be around the 1-1.5 per cent mark and Japanese growth will be just above 0, so world growth is slowing.
The dichotomy between the emerging and developing world will remain. This is in part because of the urgent need to grow per capita incomes in the emerging economies.
The pace of economic activity is easing. This is driven by lower world trade volumes playing out mainly through the visible goods markets, i.e. the production side, like cars. The services activities are holding up much better as is consumer confidence which is partly related to the high levels of employment.
"70 per cent of the world economy is slowing."
The shape of the world’s economy has shifted towards the new technologies and the technological revolution which is going on in the background. The fourth industrial revolution that is taking place despite the policy uncertainty that is still going on.
The view from the International Monetary Authority (IMF) and the Organisation for Economic Co-operation & Development (OECD) is that growth will slow down for the first half of this year and begin to pick up in the second half and further into the first half of 2020.
This is the supposition that they have and there are many countries where if you look at the individual forecasts, 70 per cent of the world economy is slowing.
But none of the major economies are in recession, which suggests that the economic backdrop is not all bad. You can pick out countries where growth is likely to be positive; Germany, France, Italy, Spain, Russia, China, India, Brazil, Saudi Arabia, Mexico, Nigeria etc., which will all be growing although some are growing below their long-run potential and are not growing fast enough to grow per capita incomes. This is particularly true in Nigeria, South Africa and Brazil.
There are few large countries which are in recession, so the good news is that there is an underpinning to economic activity at least for the next 18 months or so and there are no signs of recession.
"However, if one looks at the cyclical profile of global growth since 1980, the
forecasts for growth typically turn out to be overly optimistic"
However, if one looks at the cyclical profile of global growth since 1980, the forecasts for growth typically turn out to be overly optimistic as in every decade, there is a spike downwards.
This time, there is no expectation of a spike downward, just a gentle decline. This could be wrong; that the probability of a downturn, which is implied by the episodes since 1980 is incorrect, that this time there won’t be a sharper downturn. But the risk is that there will be a significant slowdown, we just don’t know where the trigger of this might come from.
For the UK, Brexit is of course proving very challenging.
The analytics we do should take account of the impact that the policy change will have on the UK. There is a potential 3 per cent hit to GDP or £158 billion for the UK over a 13-year period, which would not be in inconsequential.
In terms of global financial market trends, there is weaker growth and lower inflation. Core inflation is falling everywhere both in the advanced and the developing economies. There isn’t a global inflation problem, which is good news and means that policy can respond and is doing so.
And monetary conditions are easing in a number of large emerging economies. Policy conditions are also easing within the developed economies as well, for example in the US where the expectation now is that interest rates may be cut rather than be raised in the next couple of years.
There is a view amongst some policy makers that a fall in financial markets should be met by lower interest rates. But some of us feel this encourages risk-taking and an excessive build-up of leverage and debt, which may not be the best way to manage this. There are negative interest rates in the Eurozone and Japan, which is likely to persist for longer, so this is normal.
"Core inflation is falling everywhere both in the advanced
and the developing economies."
10-year bond yields are starting to slip back as they should with weaker growth and expectations of inflation weakening across the world.
An example of this was the closing prices for 10-year bond yields in Germany which was -0.23 and the UK was 0.86. Rates of inflation in the UK were 2 per cent, so there were negative returns from holding German and UK assets. For the US, 2.12 is the 10-year return for holding bonds to maturity and the inflation is around this mark.
So the monetary policy stance is around 0 and long run, real interest rates are typically positive. Positive interest rates induce investment flows to where those investors are looking for higher returns from their money and that is why the system works.
"With negative rates, you aren’t going to get positive
return on your money."
When you have negative interest rates, they distort behaviour as you don’t know where the risks are and may accumulate too much risk or excessively build up indebtedness. Although this is the point of lower interest rates, they are supposed to induce risk-taking, which is what they do but they lead to bubbles.
With negative real interest rates i.e. real policy rates beginning to slip back overall, it is leading to a rise in global, long-term public and private sector debt.
Of course not all debt is bad as clearly there is a matching asset on the other side, so it does depend on the behaviour of some of these assets within this context, the serviceability of it and the extent to which those who are lending money believe that they will make their money back. With negative rates, you aren’t going to get positive return on your money.
In this sort of environment, the philosophy must be that investors are looking for return of money rather than on money, which isn’t a typical investment scenario.
Fiscal balances in the public sector are negative, i.e. they are running structural budget deficits. At this point in the cycle we should be running surpluses to prepare for when there is an economic slowdown so that we can run deficits.
You also get political issues that arise out of these issues and growth public sector debt is going up around the world. The good news is that this is happening in rich countries where you might have thought they would be better able to cope with it. And the less developed countries are running much smaller deficits as appropriate to their growth profile.
Volatility versus the price to earnings ratios does suggest that, in the US in particular, there is over valuation relative to volatility.
The dollar is rising because there is the 2.12 per cent on 10-year bonds versus negative bonds in Europe and Japan and less than 1 per cent in the UK, which means that you will want to invest in US assets. In the context of the US, there seems to be a huge increase in the amount of corporate bonds which are held in high return i.e. low-yield.
"This composition has shifted towards poorer, higher default rated products,
which are showing low returns and no longer look like high-risk."
The leverage behind this seems to have gone up enormously in the past couple of years and is a high proportion of issuance of high-yield/high-risk versus low-yield versus low-risk. This composition has shifted towards poorer, higher default rated products, which are showing low returns and no longer look like high-risk.
This is always worrying as if something is high-risk it means you have less chance of getting your money back. So if it is behaving as if it is low-risk then something is wrong. This is the misunderstanding that led to the financial crisis in 2007/2008.
Everyone thought that risk was so well managed that you could hold (price) high-yield and high-risk just as you could hold low-yield and low-risk assets; but of course you can’t.
Effectively emerging market assets are not particularly overvalued. Some may be if you exclude China, so perhaps Taiwan or South Korea but not Argentina, Mexico or Turkey. Credit spreads are where there are signs of lots of liquidity, i.e. that gap between high and low-yield. And it is narrowing too much, which could imply that there are many significant bubbles forming.
Although credit for GDP ratios are high in some countries, growth in these credit growth indices are beginning to decline, which means that there is an ebbing of risk-taking in some of these markets. Investors are starting to become wary of some of these markets and instruments.
On the other hand, investors have lots of liquidity available and it does have to go somewhere. Judicious analyses of where it should go is now absolutely a prerequisite.
One of the good points is that banks don’t look to be the source of the next crisis other than perhaps European banks, where they are not as well capitalised as the US or UK banks.
Capitalisations have increased and a better mix of long-term borrowing versus short-term borrowing from markets. And more deposits and matching loans from customers means that customer funding gaps have fallen to levels that are consistent to the amount of deposits which are coming in.
This means that banks are better able to price the risk that they are taking on board. The UK is a great example of this with UK banks running customer surpluses, which means that on average, UK clearing banks have more money held from depositors than they are lending to them. This is in contrast this with 2007/08, where you could see that this was part of what led to the crisis.
In terms of the mix of assets, there has been much less recourse to short-term market funding. This is risky if markets turn against you. There are much more long-term assets in the portfolio, which are safer but also a reduction in overall asset profile anyway with the funding gap narrowing as a whole.
There are still a lot of negative-yielding bonds out there and these are clearly distortions in the markets, and they are telling us that asset prices aren’t reflecting the real risk.
In other words, if you could choose to not buy negative-yielding bonds and could buy something else such as corporate bonds which have a positive return, you would be more likely to buy them, but this will drive down the yield of corporate bonds.
So, the discrimination between the various asset classes within the corporate bond universe is less keen than it should otherwise be. This may mean excessive risk-taking.
The pricing of the risk in these corporate bonds as a slower economic growth implies that some of these companies ought to underperform and the default rate should go up. So, the reason the yields are still falling is because there is still so much liquidity being forced in because the alternatives aren’t good.
"The discrimination between the various asset classes within the
corporate bond universe is less keen than it should be"
Corporate debt to GDP ratios have risen but it implies that there may be a digestion problem when some of these bonds come to mature. They seem to be maturing over the next couple of years when the economic cycle is turning against greater issuance in a slower growth environment.
On the other hand, you could argue that if there is plentiful liquidity and so much negative yield in government bonds, then maturing bonds may need refinancing. They may be a source of investment for those looking for better returns over the next couple of years.
There is decline in the quality of corporate bonds. The share of corporate bonds with a rating of BBB rising as a proportion of the total has quadrupled over the past couple of years.
In other words, the quality of the bond mix as illustrated in the US market is suggesting that the decline of credit worthiness may be driven by the fact that returns from other areas are so low. So investors who are flush with liquidity have little recourse if they want to use their money and have to place it somewhere.
"We should be wary of negative-yielding government bonds and
the sovereign doom loop in Europe."
In terms of countries who are at risk, if you look at the average of credit booms over previous cycles, China and Canada look at risk. If you look at house prices, which are usually triggers for crisis as well as commercial property crisis, then Canada does stand out, but China stands out rather less. This illustrates that there are risks out there and there appear to be credit bubbles and we should be wary of this.
To conclude, we do have a slowing world economy and financial market volatility seems to not be recognising some of the policy risks that are out there.
The good news is that with low inflation, policy is showing signs of responding. But the bad news is that this may exacerbate some of the credit bubbles that we have.
We should be wary of negative-yielding government bonds and the sovereign doom loop in Europe.
Many European banks, who are worried about their capital positions, are holding what they think are safe government asset, which are anything but safe. I am reminded by a comment by John Maynard Keynes who said that if the facts change, he likes to change his conclusions and I would say the same.
