As we approach year-end it is a good time to assess the outlook and some of the key issues facing the global economy. In this piece, I focus on the risks that lie ahead that could impact the outlook for markets and the behaviour of investors.
Such risks can be broken down into three broad categories: economic, financial and political.
The main economic risk might be termed an opportunity, too: that we don’t fully appreciate the extent to which the world economy is growing. It is a decade since the last business cycle peak, prior to the 2008 global financial crisis. The world economy hit bottom in the summer of 2009, since then the US and UK have enjoyed eight years of an economic upswing. Now this upswing is more synchronised, with solid recoveries being seen in the EU and Japan, and China is stabilising, with market fears of a hard landing having receded.
The main driver behind this has been policy stimulus, which has helped the deleveraging process that was evident immediately after the financial crisis.
But there are also some longer-term trends at play that should help the future economic outlook. These gains may not always be apparent, and in the near term we may see much transition and dislocation as firms adjust behaviour. Some countries may gain at the expense of others. These trends include the rise of economies such as China and India, China’s One Belt Road policy, which is triggering the biggest ever infrastructure boost across multiple economies and the Fourth Industrial Revolution.
While it may seem strange to refer to stronger growth as a risk, it will be if we are not anticipating or preparing for it. In particular, one of the big questions for 2018 is what happens to inflation. There are many factors at work, such as technology that keeps costs down and suppresses inflation. Yet as unemployment falls and labour markets tighten, wage growth may start to rise. This could force up costs and inflation. This risk needs to be monitored, although the recent decision of Organisation of Petroleum Exporting Countries (OPEC) countries to boost supply may restrain oil prices, often a source of inflation shocks in the past. The global reflation currently underway necessities monitoring inflation risks, particularly in economies that appear to have little spare capacity and are growing above trend, such as the US and UK.
There are a number of reasons why this stronger economic outlook is not being celebrated in the way we might expect. One, growth has been overly dependent upon low interest rates. Thus the fear is when monetary policy is tightened, growth will slow. Faced with this, central banks need to move gradually. Given it took eight years to ease policy, by cutting rates and printing money, perhaps it should take just as long to reverse the process fully. An additional challenge is that across the world, central bankers are increasingly uncertain about what is driving wages, inflation or productivity. Therefore how central banks exit from low rates and quantitative easing will be key for both economies and financial markets.
These, too, can be broken down into a number of categories. Perhaps the biggest risk is that of regulatory overkill. Ahead of the financial crisis, the regulatory pendulum was at one extreme, being too light. It has since swung to the other extreme, of being too heavy. Perhaps, like a pendulum, it needs to settle in the middle.
An unintended consequence of regulatory overkill is the rise of the shadow banking industry. This is hard to define fully, but according to the Financial Stability Board, includes groups such as “investment funds, broker-dealers, captive financial Institutions and money lenders”, among others. In essence, the main point is that while capital requirements on banks have risen, a range of other financial institutions who do not face such capital restraints have taken on a much bigger role within the financial system, and increased their leverage in the process. The good news then is that banks are far more resilient than previously, but the challenge is that the rise of shadow banking means that stability risks may have been created elsewhere in the financial system.
"This has also fed to financial markets displaying shades of how they were ahead of the 2007-08 crisis. Markets were not pricing for risk then. Their behaviour now makes many fear a major financial market correction is due."
There is also a significant amount of change impacting the financial sector – the rise of FinTech being the best example. Ultimately this should be good news, but it can add to transition costs in the near term.
While the costs of servicing debt for households and firms in many Western economies is low, the worry since the financial crisis has been the rise in public sector debt. This problem is most apparent in economies like Japan but is no less a worry in the UK, where public debt is at its highest level in peacetime. In the decades after the Second World War, UK debt was much higher because of the War and then fell sharply, helped by solid growth in nominal GDP (growth plus inflation) and relatively low rates and yields. Such an environment can be repeated now – in the UK and elsewhere. If not, then markets will start to worry about how debt levels can be reduced: inflation, write-downs, or even higher taxation, among others.
Political risk – either domestic or geopolitical
The domestic political risks are not just to be seen in the UK. Low productivity, for instance, is an economic challenge in itself, adding to risk. Low productive economies have lower trend rates of growth, and also see wages rise at only a slow pace. If more people feel that they are not sharing in economic success, or are not meeting their expectations, then this could trigger political change in the future – and lead financial markets to factor in greater political risk now. The UK also faces the uncertainty associated with Brexit, although it now looks as though the negotiations are moving on to the topic of transition and future trade.
There are always regional hotspots such as The Middle East, South and East China Seas and North Korea. The fear of these can lead to a flight into safe assets, often seen to be government bonds, high quality corporates and even the dollar or yen.
The post global financial crisis environment has also seen the rise of extreme and fringe parties across many countries, and the rise of populism. It has contributed to unexpected political outcomes in recent years, and if there is another economic or financial shock then radical policies may take centre-stage in Western economies.
Trade tensions are one potential consequence of this, with most eyes on the US President and his likely approach to trade agreements.
Finally, structural change may lead to institutional change on many levels. One example may be at the US Federal Reserve Board, where many key personnel changes are taking place, another may be at other global policy fora, including the United Nations, where emerging economies are seeking greater representation.
It is always important to take into account risks in order to reach a balanced investment decision. We continue to monitor risks, and to keep them in context and perspective. They also need to be judged alongside the opportunities. In a forthcoming piece we will focus on the opportunities and the outlook for 2018.