What are the risks facing the economic outlook and the financial markets? The tenth anniversary of the collapse of Lehman Brothers has prompted much comment on whether another global financial crisis might be imminent. Often when this is debated it reflects wider concerns such as the valuation of some markets, or how resilient global growth will be in the face of tighter monetary policy. It is also important to be on top of potential risks, and to assess them properly.
Let’s highlight some of the issues that dominate the risk outlook. Earlier this week I gave a keynote speech at a global risk conference, and later this month I will take part at the annual FT investment conference, speaking about risks. So, what are these threats? I would group them into economic, financial and geopolitical risks.
The key issue in considering economic risks is sustainability. That is, how sustainable is the present pace of global growth? Last year the world economy grew strongly. This year, however, the picture across countries is mixed. Even though the recent picture of growth has been uneven, 2018 looks set to be a year of strong overall growth for the world economy.
In a few weeks, at their annual meetings in Bali, the International Monetary Fund will provide their latest forecast for the world economy. At the time of their latest update, in July, they expected global growth of both 3.9% this year and next, after 3.2% in 2016 and 3.7% in 2017. While this is a strong pace of growth there are signs that the global economy may be losing momentum.
The decade since the global financial crisis has been a case of differentiating between the West versus the Rest (of the world). Yet this year it is more a case of the need to differentiate between the US and the Rest of the West. Helped by tax cuts and an easier fiscal policy the US economy and assets have outperformed, and the dollar has been firm, although recently it is off its highs.
In terms of sustainability, the issues to focus on include: the slowdown in world trade (which has been evident for some time as the graph below shows), the impact of the escalating trade war and how much this will affect the US and China, and how resilient economic growth in the West will be in the face of monetary tightening.
Growth in the euro area, for instance, has been particularly weak recently versus previous market expectations. Meanwhile, in the face of escalating trade tensions, China has eased policy (as we covered here last week) and this may help limit the pace of the slowdown there. Debt levels, too, across the globe, reinforce the need to focus on economic risks and the importance of sustainability.
Source: Bloomberg, CPB
In terms of financial risks, the key word is unconventional. The last decade has witnessed unconventional monetary policies. How resilient will economies and markets be as central banks opt to reverse their unconventional policies? Ideally, central bank policies should be gradual and predictable, as they normalise policy.
It is, however, the valuation of markets that is one of the major issues, and whether, as was not the case a decade ago, markets are pricing sufficiently for risk. For instance, the combination of high debt levels and higher rates, depending on the market one is looking at, adds to a renewed focus on credit risks.
When it comes to geopolitical risks, the key word is friction. There is increased friction in a host of areas, for example, in the trade issues between the US and China. Numerous geopolitical issues come to the fore from time to time, as we have seen in recent weeks.
Yet when one looks at the VIX index (the most common benchmark of market volatility), or the oil price (where in times of crisis a risk premium is often factored in), it is not clear that markets are pricing in geopolitical risks to any great extent. Often, that is because it is a case of small probability, high impact events. That is, there is often a lot of noise about geopolitical issues, but often these do not escalate. But when they do, it can have a big impact, particularly if, say, oil prices are forced higher.
The big geopolitical worry is trade, and whether it dampens global growth in coming months, and also whether it spills over into the wider relationship between China and the US. Thankfully, Presidents Trump and Xi are due to meet twice this autumn, and the expectation is that this will allow a potential defusing of current tensions, and certainly not an escalation of them.
These issues, naturally, figure in our investment thinking. In the face of increased risks, for instance, are there safe havens? One of our ongoing themes is that it is “time in the markets”, not “timing the markets” that is key. It is hard to identify turning points exactly but getting the balance correct between macro-economic indicators and market valuations is important.
Some assets may appear safer than others – for instance, the yen may be a good counter-cyclical allocation offering protection in some portfolios. There are others. But overall, the key is to not lose sight of what is happening now (such as a strong US economy), or of the positive longer-term global fundamentals, but also to ensure we take into account the need to price properly for risk. Here we have highlighted three key words reflecting this: sustainability, unconventional and friction.
Please remember that when investing your capital is at risk.