Global Economic Outlook 2020

I thought I'd start 2020 by looking at some global economic forecasts not because I believe the precise numbers but because it provides a gist for what's going to happen in the year ahead central case if you will and then we'll look at some tail risks which are the low probability events which could potentially have a very large impact on your portfolio so remember if any of this concerns you or you want to discuss it in more detail you can always schedule a one-to-one Power Hour with me but now let's start to look at those economic forecasts but also the tail risks in a bit more detail this is not recommendation if you want advice tailored to your specific circumstances seek independent financial advice let’s start by looking at some global economic forecasts this is the IMF World Economic Outlook and it was published in October of 2019what's noticeable is that for advanced economies there's quite a marked deceleration of growth in 2019 and in2020 although in emerging markets there’s a bit of a bounce back from 3.9percent growth to 4.6 percent growth in2020 and in fact global growth was downgraded by the IMF for 2019 to just 3percent and that's the slowest growth since the global financial crisis we’ve gone from a synchronized upswing in growth in 2017 to a synchronized downswing and the reason given for this by the IMF is rising trade barriers uncertainty in trade and geopolitics strain in particular emerging market economies and long term trends or structural factors such as low productivity growth and an aging global population particularly in advanced economies the World Bank outlook is slightly different in terms of specific numbers but the general trend is the same with global growth falling to 2.6percent in 2019 and only rising slightly to 2.7 and 2020 and 2.8 in 2021 and they see the same upswing in emerging markets as the IMF so that's four percent in2019 and 4.6 percent in 2020 and 2021one of the positives for growth is benign global financing conditions in other words low interest rates they say that risks are firmly on the downside because of destabilizing policy developments such as trade tensions between major economies renewed financial turmoil and sharper than expected slowdowns in major economies you can certainly see the slowdown in manufacturing since the beginning of 2018 and business confidence has also been eroded so think of that as your central case that's what happens if nothing catastrophic goes wrong but it's always worth thinking about the tail risks these are lower probability outcomes but they’re worthwhile considering nonetheless because they could have a great impacting the value of your investments Solet’s start with the US central bank the Fed and their tail risks these are taken from the US Federal Reserve's financial stability report which was published in November 2019 and one job of the central bank is to maintain stability of the financial system so rather than ignore the vulnerabilities this document goes into them in great detail and tries to quantify those risks one of the tables in the report which is really interesting shares a size of each of thus markets so the US residential real-estate market is about 37 trillion dollars amounts been growing pretty much in line with its growth since 1997 thus equity market is about 36 trillion dollars and in this case it's been slowing down relative to its growth since 1997 now one of the problematic markets as we'll see later is leveraged loans but that's only a one trillion dollar market but what really should catch your eye is that its growth is phenomenally fast that's a 15 percent although that's in line with its long-term growth it's well above GDP growth so at some point growth in a leveraged loan market is going to become unsustainable and inevitably the market will suffer a large correction the analysis is broken down into four sections the first one is asset valuations which tries to gauge how expensive a particular market is it cites three markets which look expensive and that's corporate debt commercial real estate and farmland so if you look at the spread which is the additional income you receive to take US corporate bond risk those have been fairly small and falling through20:19 despite the fact that leverage has been increasing and that should certainly be a cause for concern the next section is borrowing by businesses and households the pattern here is that businesses have become more leveraged whereas household leverage isn't as extreme business leverage is now historically high relative to gross domestic product and the parts of the debt market which has been growing most rapidly are for the riskiest firms but they say that household borrowing remains at a modest level relative to income so in this graph the darker lines non-financial business borrowing as a proportion of gross domestic product and that’s been gradually creeping up falling every time there's a crisis and it’s now at a level which is above whereat was just before the global financial crisis whereas household borrowing relative to GDP has fallen but in the leveraged loan market the top shaded bar shows you how much of the debt multiples are above six times so those are the most leveraged companies and you can see that's been gradually increasing since 2016 the feds made very sure that US banks have been strongly capitalized because they don’t want to repeat what happened in 2009life insurance companies also haven’t taken on too much leverage but hedge fund leverage is elevated relative tithe past five years now if you’ve watched the Big Short you'll know whites are but the issuance of the other securitized products fell off a cliff in2008 and now a lot of companies get their money through the door via leveraged loans then these are packaged up inside a collateralized loan obligation or C L o and Botha Fed and other central banks have cited leveraged loans as being problematic one of the jobs of the Fed is to stop runs on banks so funding risk is a big deal so the Fed wants to ensure that banks don't have too many assets which they can't shifting the event of a run they've got to have enough liquid assets to be able to pay back their customers money the wholesale funding market which dried upon 2008 and 2009 is used much less now than it was just before the crisis and the feds done its job which is to ensure that the ratio of high-quality liquid that’s easy to sell assets makes up a large part of the balance sheets of banks however mutual funds which in the UK we call an open-ended investment company or oak are holding great amount of high-yield debt those are the riskiest bonds and that’s largely as a result of yields being Solow now that's a problem because if there’s a downturn in the high-yield market those mutual funds may not be able to sell their high-yield bonds quickly enough to meet the redemptions of their clients and that may lead to funds being gated as we saw for Woodford in the UK so the holdings of US corporate bonds has reached 1.5 trillion and that's well above where it was before the global financial crisis and lowest credit quality bonds or high-yield bonds and bank loans make up large proportion of those mutual fund assets the Fed conducted a market outreach program where they asked several banks what they consider to bathe biggest risks and what came out top was trade frictions and the second was global monetary policy efficacy so the question there is whether monetary policy in other words low interest rates and quantitative easing will actually help the global economy liquidity is also a concern so how easy is it to sell assets in the event of a downturn and Expect one of these categories which is Iran will probably score more highly given recent news and the lease wearing factors were a passive investing bubble politics and household debt the use is worried that the European economies could have a blowback effect on the US economy via financial and economic linkages with the United States which would mean an economic downturn in Europe could affect the US financial system one of the mechanisms for this would be a reduction in risk appetite due to uncertainty around what's going on in Europe and that could trigger sell-off in assets in the United States the European banking system could also cause a blowback to the United States via credit exposures and via international dollar funding markets and another mechanism of transmission would be through trade channels no deal Brigg sit also figures on the risk radar forth Fed in particular the risk of anodal Briggs it in 2020 that could trigger markets in economic disruptions and that could spill over to global markets systemically important for and institutions or cities in Europe would also be a conduit for brevity to affect global financial systems given the size of the Chinese economy distressing China could also spill over into thus and global markets by diminishing risk appetite when that occurs he usually get US dollar appreciation as people opt to buy the safest currency in the world and given the size of China’s trading relationships that would also cause a decline in trade and also its huge demand for commodities which would push down commodity prices China’s trying to deflate its credit bubble there’s still the risk that it could pop very rapidly and cause a sharp downturn even though it's been managed very well so far there's also a huge and hardly regulated shadow banking sector in China and that's highly interconnected with banks and that's a vulnerability for the Chinese financial sector now there are several triggers which could pop that credit bubble it could be escalation in the trade conflict the crash in the Chinese property market or a high profile corporate default the Fed also considers what would happen if the US economy were to slow unexpectedly the initial effect would be to reduce the profits of on-financial businesses and given the amount of borrowing which has gone on that could lead to financial stress and default rates picking up so more bankruptcies in that kind of environment investors pull back on their risk and by selling assets prices would decline significantly in particular expensive markets such as high-yield bonds and commercial real estate and that would affect the financial system because banks would be less willing to lend and it could also trigger a wave of selling now let's look at the Bank of England’s tail risks they have this nice heat map which breaks down the data into households and companies and it ranges from just before the global financial crisis in 2007 to the latest data the region which comes up red for household data is China where the debt to GDP for households is at elevated levels in the corporate space the United States has Avery high debt to GDP and those worries are focused in the leveraged lending space so those are the leveraged loans which we saw earlier and just as it is in the household space China's flanks read in the corporate lending space that shadow banking sector that we were talking about in China can be quantified with this total social financing number and you can see that China has been trying to shrink the size of total social financing very gently to avoid popping their credit bubble but the Bank of England is also concerned that the bubble could still pop then in particular the Bank of England is worried about linkages to the Financial system and that's because a lot of UK banks have a large exposure to mainland China drilling into the corporate debt story the Bank of England flanks the use as having a very high corporate debt to GDP ratio and they also flagged France as reaching its historical highs on that measure but French authorities are trying to address that problem and again we see that one of the worries is us leverage loans where credit quality is deteriorating with over half of the leveraged loans issued in 2019 having very high debt toe BIT Darrow's so that's the amount of debt a company has relative to its earnings before interest tax depreciation and amortization that’s just an accounting measure of the amount of money coming through the door of companies and when it's above 6 then it’s time to worry but it's reassuring to see the Italy's corporate indebtedness continues to fall household and corporate credit growth isn't too bad in the euro area but the amount of sovereign debt in some countries in particular Italy is still an issue and the sovereign debt crisis that we saw in Europe in 2012 has still not truly been resolved and there is still strong into linkages between banks and sovereigns so if there was a sell-off in Italian government bonds it could severely impact Italian banks who hold a lot of that sovereign debt but the ECB's been very careful to make sure that the balance sheets of European banks now have more loss-absorbing capital than they did just before the financial crisis however the CET 1 ratio has improved partly because of a financing fiddle which is the risk weights being adjusted on their assets so there’s still some work to do on balance sheets and European banks now let's look at the European Central Bank's tail risks they’ve certainly outdone them with their flowcharts which are very impressive and they point out that there’s a very low yield environment in Europe given the weak growth that we’re seeing in Europe that creates a worry about debt sustainability and in particular there's a great amount of triple-b debt which is a lowest rating for investment grade in other words there’s a huge amount of debt which is just one credit rating notch away from being downgraded to junk banks are also less profitable ironically that’s largely because they can take less leverage due to regulation by the central bank and three-quarters of euro area banks have a return on equity of below 8% that's far below what it was when they could take more leverage before the financial crisis and in this low yield environment there's been a reach for yield and that means that investors have had to take greater risk either by buying lower quality credit or taking more duration risk and some of these high-yield assets are very illiquid which means that if there's a crisis the asset managers may not be able to sell the assets so given the weak GDP growth in the euro area that doesn’t sit well with companies increasing the leverage on their balance sheet but because of low interest rates house prices in many of the euro area countries are rising rapidly but the valuations are contingent on there being very low interest rate and as a consequence if interest rates do increase then this asset miss pricing could cause a rapid correction and that applies to the equity market which is benefited from low interest rates but also gold and other safe-haven assets such as government bonds negative yields have been a real problem for banks in the euro area and that's reduced their interest margin which is the difference between the rate at which they lend and at which they borrow and the ECB thinks that return on equity could fall furthering 2020 although insurers have got fairly liquid assets still investment funds have been forced to buy the illiquid high yielding assets which could cause problems in the event of market turnaround and almost three-quarters of insurance and pension funds bond holdings now yield less than1% in the Eurozone finally let's look at the IMF's tail risk that's the International Monetary Fund the effect of US tariffs on global markets are very marked toucan see each of the rounds of tariffs reduced world equity prices particularly in those sectors exposed to trade and technology tensions so every time there’s a new round of tariffs one two three and four you can see equity markets sell off to some degree whilst at the same time the Fed speeches tend to rally markets as monetary policy applies a band aid to the global economy the credit markets were also affected by tariffs but probably to a smaller extent and volatility in the United States as measured by the VIX index some people call it the fear index was also affected by the tariff announcements so here’s the round trip and Fed monetary policy they started hiking rates in 2017 it plateaued for a while in 2019 and now the reverse course and started cutting and market expectations that other central banks will follow suit in Canada the UK and even for central banks where rates are currently negative and the trend has been a steady fall in yields since October 2018 in advanced economy government bonds a negative yielding advanced economy government bonds now make up a large proportion of the total amount of bombs outstanding but the market expectation is that that will fall over time although it's not such a large market leveraged lending in Europe has also grown rapidly and at the same time the credit quality and which is called a covenant protection as generally weakened so these are called covenant light loans and the percentage of new issuance which is covenant light has grown dramatically and you can see that huge rise in non-bank lending in the United States since 2012 with larger percentage of those loans having very high leverage and greater risk of bankruptcy let's finish by looking at the political risks markets have been largely driven by this China US trade war so whenever there's been sign of progress in the us-china trade deal negotiations equity markets have rallied and bonds have sold off and if there's deterioration in the relationship we swathe opposite it looks like we're going to get a signing of the phase 1 trade deal on 15th of January and although that’s promising it may open up a new front in the trade war with Europe Trump’s decision to kill Aqsa Soleimanicould also have very large impacts depending on how Iran chooses to retaliate and a war in the Middle East certainly has the prospect of destabilizing global financial markets depending on what the form of retaliation is and how the dispute escalates one source of dispute has been how much US tech giant's paying tax in Europe and the US has threatened trade tariffs in retaliation for those decisions in Europe and this has the prospect of triggering a new front in the trade war a more long-term worry is the effect of climate change on investment the bushfire emergency in Australia is one example of that and it’s interesting that central banks are now also starting to talk about climate change and the economic impacts of climate are very real so for example here’s a lady who works in a museum who simply couldn't work because even inside the museum she was still affected by the smoke it's hard to expect people to be productive if they can't breathe so while this isn't an immediate threat to investment it's certainly something to consider as a longer-term risk so the trend for 2020 seems to be one of slowing global growth and of course there are always tail risks at the moment the biggest seems to be too much borrowing in the United States in the leveraged loan market but also too much triple B debt which is the lowest level of investment grade and China there’s always a credit bubble in China which has us worried but never quite seems to materialize so remember.