The global economic outlook for 2020 is one of slowing growth. In this blog we look at the central case for the global economy in 2020 and also at some of the most significant tail risks.
I believe these central case forecasts are useful, not because I believe in the precise numbers, but more because it provides us with a gist for what's going to happen in the year ahead.
Tail risks are lower probability events, however if they were to happen they could potentially have a very large impact on your investments.
Global Economic Forecasts 2020 - Central Case
International Monetary Fund (IMF) World Economic Outlook
This forecast was published in October 2019 IMF World Economic Outlook
What's noticeable from their figures below is that for advanced economies there's a marked deceleration of growth in 2019 and 2020 but in emerging markets there is a bounce back from 3.9% to 4.6% growth in 2020.
The IMF explains this as follows:
“The global economy is in a synchronized slowdown, with growth for 2019 downgraded again—to 3 percent—its slowest pace since the global financial crisis. This is a serious climbdown from 3.8 percent in 2017, when the world was in a synchronized upswing. This subdued growth is a consequence of rising trade barriers; elevated uncertainty surrounding trade and geopolitics; idiosyncratic factors causing macroeconomic strain in several emerging market economies; and structural factors, such as low productivity growth and aging demographics in advanced economies.”
World Bank Economic Outlook
The World Bank Economic Outlook published in June 2019 is slightly different in terms of specific numbers to the IMF, but the general trend is the same.
They show global growth as falling to 2.6% in 2019 and only rising slightly to 2.7% in 2020 and 2.8% in 2021.
They also see the same upswing in emerging markets as the IMF; 4% in 2019 and 4.6% in 2020 and 2021.
In the graph below you can certainly see the slowdown in manufacturing since the beginning of 2018 and also that business confidence has been eroded.
The World Bank states in their report:
“Global growth in 2019 has been downgraded to 2.6% reflecting weaker-than-expected international trade and investment at the start of the year. Growth is projected to gradually rise to 2.8% by 2021, predicated on continued benign global financing conditions, as well as a modest recovery in emerging market and developing economies (EMDEs) previously affected by financial market pressure. However, EMDE growth remains constrained by subdued investment, which is dampening prospects and impeding progress toward achieving development goals. Risks are also firmly on the downside, in part reflecting the possibility of destabilizing policy developments, including a further escalation of trade tensions between major economies; renewed financial turmoil in EMDEs; and sharper-than-expected slowdowns in major economies.”
Global Economic Outlook 2020 - Tail Risks
So far in this blog we have covered what you can think of as the central case. The central case is what forecasters say will happen if nothing catastrophic goes wrong.
However it's always worth thinking about the tail risks. These are lower probability outcomes that are worthwhile considering because they could have a significant impact on your investments if they do occur.
If you would like to talk to me one-to-one about how any of this may impact your investment or ask me any other questions, then you can do this by signing up on our website for a Power Hour with Ramin
The Fed's Tail Risks
The US Central Bank’s (Fed's) tail risks are taken from the US Federal Reserve's Financial Stability Report, which was published in November 2019.
One job of the Central Bank is to maintain stability of the financial system. In this document rather than ignore the vulnerabilities the Fed goes into them in great detail and tries to quantify those risks.
The table below from the report is interesting as it shows the size of each of the US markets.
The US residential real estate market is about $37 trillion and has been growing pretty much in line with its growth since 1997.
The US equity market is about $36 trillion and has been slowing down relative to its growth since 1997.
One of the problematic markets is leveraged loans. Leveraged loans are only a $1 trillion market but what really catches the eye is that its growth is phenomenally fast at 15%. Although that's in line with its long term growth, it's well above GDP growth, so at some point growth the leveraged loan market is going to become unsustainable and inevitably the market will suffer a large correction.
The Fed’s analysis is broken down into four sections.
The first one below is "Asset Valuations", which tries to gauge how expensive a particular market is.
It cites three markets which look expensive; corporate debt, commercial real estate and farmland.
If you look at the spread, which is the additional income you receive to take US corporate bond risk, these have been fairly small and falling through 2019. This is despite the fact that leverage has been increasing, which should certainly be a cause for concern.
The next section is "Leverage (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 (GDP) and the parts of the debt market which have been growing most rapidly are for the riskiest firms.
The report also says that household borrowing remains at a modest level relative to income.
You can see this in the top graph (below), where the darker line is non-financial business borrowing as a proportion of gross domestic product. This has been gradually creeping up, then falling every time there's a recession and now it is at a level which is above where it was just before the global financial crisis.
You can also see from this graph that household borrowing relative to GDP has fallen.
In the bottom graph you can see the leveraged loan market. The top shaded bar shows you how much of the debt multiples are above six times (these are the most leveraged companies) and you can see that is has been gradually increasing since 2016.
The third section of the report is "Leverage in the Financial sector".
The Fed has made very sure that US banks have been strongly capitalised because they don't want to repeat what happened in 2009. Life insurance companies also haven't taken on too much leverage but hedge fund leverage is elevated relative to the past five years.
If you've watched the Big Short you'll know what CDOs are and the issuance of this and other securitised products fell off a cliff in 2008.
Now a lot of companies get their money through the door via leveraged loans. These are packaged up inside a collateralised loan obligation or CLO. Both the Fed and other central banks have cited leveraged loans as being problematic.
If you want to find out more about how CDOs and CLOs are packaged then take a look out my blog Michael Burry - An Index Bubble? where I give you a detailed explanation.
The fourth area of the report is "Funding Risk".
One of the jobs of the Fed is to stop runs on banks. Funding risk is important so the Fed wants to ensure that banks don't have too many assets which they can't shift in the event of a run. They have got to have enough liquid assets to be able to pay back their customers' money.
The wholesale funding market which dried up in 2008 and 2009, is used much less now than it was just before the crisis. The Fed has done its job which is to ensure that the ratio of high-quality liquid (easy to sell) assets make up a large part of the balance sheets of banks.
However mutual funds, which in the UK we call an open-ended investment company (OEICs), are holding a great amount of high-yield debt. These are the riskiest bonds and that's largely as a result of yields being so low. This is a problem because if there is 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. This may lead to funds being gated as we saw for Woodford in the UK.
You can find out more about what went wrong with Woodford by watching my video Woodford - What Happened & What Can We Learn
The holdings of US corporate bonds has reached $1.5 trillion (that's well above where it was before the global financial crisis) and the lowest credit quality bonds (high-yield bonds) and bank loans make up a large proportion of those mutual fund assets.
The Fed conducted a market outreach program where they asked several banks and fund managers what they consider to be the biggest risks. Trade frictions rated first with global monetary policy efficacy second. The question with monetary policy efficacy is whether low interest rates and quantitative easing will actually help the global economy.
Liquidity is also a concern e.g. how easy it is to sell assets in the event of a downturn.
Iran, further down the list, would probably score more highly now given recent news.
The least worrying factors were a passive investing bubble, politics and household debt.
In the report the Fed also went on to cite the following tail risks:
- “European economies have notable financial and economic linkages with the United States, and a sharp economic downturn in Europe would likely spill over to the U.S. financial system.
- Adverse economic and financial developments in Europe could heighten uncertainty and lead to a sharp pullback of investors from riskier assets, amplifying market volatility and declines in asset prices.
- Stresses in European banks could also be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities, including dollar funding markets.
- Moreover, the consequent dollar appreciation and lower global demand in the event of a sharp downturn in Europe would weaken the U.S. economy through trade channels, impairing the creditworthiness of U.S. exporting firms.
- The UK and the EU have agreed to a Brexit extension until January 31, 2020, but the risk of a no-deal Brexit in 2020, while diminished, still persists.
- A no-deal Brexit could trigger market and economic disruptions in Europe that might spill over to global markets, leading to a tightening of U.S. financial conditions.
- Should a no-deal Brexit cause distress in systemically important financial institutions in Europe, it would amplify the transmission of economic disturbances to U.S. and global financial systems.
- Because of the size of the Chinese economy, significant distress in China could spill over to U.S. and global markets through a retrenchment of risk appetite, U.S. dollar appreciation, and declines in trade and commodity prices.
- A prolonged period of rapid credit expansion in China has rendered its nonfinancial corporate sector highly vulnerable to a sharp downturn.
- In addition, poor asset quality and notable interconnections between banks and the large and weakly regulated shadow banking sector leave the Chinese financial sector vulnerable.
- In this context, near-term risks such as an escalation in the trade conflict with the United States, a rapid adjustment in property prices, or a high-profile corporate default may trigger financial instability that could be transmitted globally.
If the US economy were to slow unexpectedly...
- profits of nonfinancial businesses would decrease, and, given the generally high level of leverage in that sector, such decreases would likely lead to financial stress and defaults at some firms.
- Investor risk appetite and asset prices may decline significantly in such a scenario, especially in markets such as high-yield bonds and CRE, where valuations are elevated.
- In addition to generating losses for the holders of the assets, a decline in asset prices could affect the financial system more generally either by impairing the ability of some financial institutions to lend or by inducing a wave of selling and redemptions of withdrawable liabilities."
The Bank of England's Tail Risks
In the Bank of England Financial Stability Report – December 2019 they have a useful heat map (below). This 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 a very high debt to GDP ratio. Those worries are focused in the leveraged lending space which are the leveraged loans which I talked about earlier.
Just as it is in the household space, China's is flagged as red in the corporate lending space.
A large amount of lending in China is by non-banking entities (the shadow banking sector) the size of which can be quantified with the total social financing number in the graph below.
You can see from the graph that China has been trying to reduce the rate of growth of total social financing very gently to avoid popping their credit bubble.
However, The Bank of England still has concerns about the Chinese credit bubble popping. This is because of the strong linkages to the UK financial system where UK banks have a large exposure to mainland China.
Drilling into the corporate debt story, the Bank of England flagged the US as having a very high corporate debt to GDP ratio. They also flagged France as reaching its historical highs on that measure despite French authorities trying to address this problem.
Again we see that one of the worries for the Bank of England is US leveraged loans, where credit quality is deteriorating with over half of the leveraged loans issued in 2019 having very high debt to EBITDA.
EBITDA is the amount of debt a company has relative to its earnings before interest tax depreciation and amortisation and when it's above six then it's time to worry.
It is however reassuring to see that 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, particularly Italy, is still an issue.
The sovereign debt crisis that we saw in Europe in 2012 has still not truly been resolved and there are still strong linkages between banks and sovereigns. If there was a sell-off in Italian government bonds it could severely impact Italian banks who hold a lot of that sovereign debt.
The ECB's has 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. The CET1 ratios (core equity tier 1, which is the regulator's core measure of a bank's financial strength) have now improved but this is partly due to a financing fiddle where the banks risk weights are being adjusted on their assets.
European Central Bank's Tail Risks
The European Central Bank (ECB) have outdone themselves with some impressive flowcharts in their Financial Stability Review, published in November 2019.
In the illustration below they point out that there is 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 the amount of BBB debt (the lowest rating for investment grade debt). 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. Three-quarters of euro area banks have a return on equity of below 8% and that's far below what it was when they could take more leverage before the financial crisis.
In this low-yield environment there's been a reach for yield. That means that investors have had to take greater risk either by buying lower quality credit or taking more duration risk to get the yield they want. 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 quickly.
Given the weak GDP growth in the euro area, that doesn't sit well with companies increasing the leverage on their balance sheet.
Because of low interest rates house prices in many of the euro area countries are rising rapidly. Valuations are contingent on there being very low interest rates. As a consequence if interest rates do increase then this asset miss-pricing could cause a rapid correction. That correction will apply to the equity market which has benefited from low interest rates but also to 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 has reduced their interest margin, which is the difference between the rate at which they lend and at which they borrow. The ECB thinks that return on equity could fall further in 2020.
Insurers still have fairly liquid assets but investment funds have been forced to buy the illiquid high yielding assets which could cause problems in the event of a market turnaround. Also almost three-quarters of insurance and pension funds bond holdings now yield less than 1% in the euro zone.
International Monetary Fund Tail Risks
Finally let's look at the International Monetary Fund’s (IMF) Global Financial Stability Report, published in October 2019.
Below, In the top left graph you can see that the effect of US tariffs on global markets are very marked. Each round of tariffs reduced world equity prices, particularly in those sectors exposed to trade and technology tensions. This means that every time there has been a new round of tariffs you can see equity markets sell off. Whilst in contrast you can see that markets rally when the Fed has made speeches as monetary policy applies a band aid to the global economy.
Below, in the top middle graph you can see the credit markets were also affected by tariffs but probably to a smaller extent. Whilst in the graph to the right, you can see volatility which in the United States is measured by the VIX index, some people call it the fear index and this was also affected by the tariff announcements.
In the bottom left graph you can see the round trip of Fed monetary policy. They started hiking rates in 2017, it plateaued for a while in 2019 and now they have reversed course and have started cutting. Market expectations are that the other central banks will follow suit; in Canada, the UK and even for central banks where rates are currently negative.
In the bottom centre graph you can see the trend has been a steady fall in yields since October 2018 in advanced economy government bonds.
In the bottom right graph you can see that negative yielding advanced economy government bonds now make up a large proportion of the total amount of bond 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. At the same time the credit quality, which is called a covenant protection, has generally weakened. These are called covenant light loans and the percentage of new issuance of these has grown dramatically.
There has been a huge rise in non-bank lending in the United States since 2012. With a larger percentage of those loans having very high leverage and greater risk of bankruptcy.
Global Economic Outlook 2020 - Political Risks
Markets have been largely driven by the China US trade war. Whenever there have been signs of progress in the US China trade deal negotiations equity markets have rallied and bonds have sold off, but when there has been a deterioration in the relationship we have seen the opposite occur.
It looks like we're going to get a signing of the Phase One trade deal on 15th of January. Although that's promising it may open up a new front in the trade war with Europe.
Trump's decision to kill Qasem Soleimani could also have a very large impact depending on how Iran chooses to retaliate. A war in the Middle East certainly has the prospect of destabilising 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 giants pay in tax in Europe. 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 this and what’s interesting is that now even central banks are also starting to talk about climate change.
The economic impacts of climate are very real. For example below is 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.
In conclusion, the trend for the 2020 the economic forecasts seem to be one of slowing global growth.
The biggest red light at the moment in respect to tail risks seems to be too much borrowing in the US leveraged loan market, with too much triple B debt. In China there's the credit bubble which also has us worried but never quite seems to materialise.
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