Friday HighlightSep 21 2018

What is sowing the seeds for the next financial crisis?

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What is sowing the seeds for the next financial crisis?

But with any extraordinary policy response comes unintended consequences, some of which could be sowing the seeds for the next crisis.

Since Lehman, central bankers have collectively continued asset purchases coupled with exceptionally low rates which is only now coming to an end.

Instability resides with those assets that overly depend on cheap money.

Prolonged easy money has increased vulnerability in the form of dependence on deficit financing, excessive debt build-up and pockets of asset bubbles that eventually will need to deflate as rates rise. As central bankers wind down their asset purchase programs and financial conditions increasingly tighten, we see several key risks.

Rising debt levels

Emerging markets (EM) currently appear at the epicentre of rising risks, but vulnerabilities are more idiosyncratic than structural.

The risk of contagion is still limited, simply because most of EM has saved more and reformed past the external vulnerabilities of Turkey and Argentina – particularly in Asia where savings rates are high and ongoing reforms are paving the way for more balanced growth.

More worryingly, cheap money has led to a broad build-up in global debt, mainly among corporates and also developed market sovereigns that have more than offset the benefits of consumer deleveraging since 2008. US corporates have participated in the binge as well as corporates in EM, most notably in China. 

Just as asset purchases over the last decade were unprecedented and largely experimental, so will be the experience of winding down these programs.

The US more than doubled its sovereign debt load over the last 10 years, yet interest costs declined with falling rates and new supply limited by US Federal Reserve asset purchases – essentially, painless deficit spending.

Today, supply is increasing both for widening fiscal deficits and balance sheet reduction. Coupled with higher interest rates, this is beginning to crimp demand for risk assets. Similar dynamics will be at play as the European Central Bank (ECB) and potentially the Bank of Japan (BOJ) are ending their own asset purchasing programs.

Against this backdrop of higher debt levels with rising rates, there is an elevated risk of a policy mistake.

Just as asset purchases over the last decade were unprecedented and largely experimental, so will be the experience of winding down these programs.

Risk impact in an asymmetric risk environment

While elevated policy risk suggests unanchored inflation expectations or a possible hard landing, the more likely outcome is a grinding reversal of quantitative easing (QE) induced flows, requiring deleveraging and debt restructuring that policymakers have seemingly long sought to avoid.

For the first time since 2008, aggregate central bank balance sheets – the Fed, ECB, BOJ and the People's Bank of China – are beginning to contract.

Net liquidity withdrawal adds to volatility and likely the speed of crisis development as witnessed in the fast evolving currency crises in Turkey and Argentina.

Not surprisingly, sudden downturns in an asset tends to drag down the broad asset class – in this case EM – despite vast differences in terms of vulnerability and growth outlook across the complex.

It makes little sense, but to those who invest for the long term, broad indiscriminate sell-offs present interesting value opportunities.

EM is less on the cusp of a broad crisis than it is on the brink of significantly diverging outlooks – savers and reformers will see brighter growth outlooks where deficit spenders like Turkey and Argentina will continue to endure harsh economic adjustments.

EM is an increasingly disparate asset class not just across geographies but across industries where pockets of excess corporate leverage will still need to adjust.

China is aggressively deleveraging, which is positive for overall stability, but opportunities in consumption and technology are vastly different than industrial SOEs prone to excessive leverage.

Different than EM, the US has suffered only minor volatility, instead reaching new equity highs, mainly attributable to tax cuts and healthy growth. Stimulus may add a year or two to an already long cycle, but the effects of monetary tightening will be increasingly apparent – particularly given the high levels of debt and high Treasury issuance that will increasingly sap demand for credit.

Rising cost of debt service will crimp profit margins and limit share buybacks.

There are many high-quality names in the US equity space, but the broad market is increasingly priced to perfection, defying a broadly shared negative outlook for the rest of the world.

Simply put, US equities are expensive and have further to fall than global peers as conditions eventually weaken.

The Pavlovian preference for historically “safe assets” holds for now, but will need to be re-evaluated in the context of current valuations against asymmetric risks. US Treasuries, the typical go-to safe asset, offered little protection earlier this year when bonds and equities sold off together.

German Bunds and Japan JGBs may face similar shifts as asset purchases continue to decline.

Interestingly, China bonds have proven among the most defensive sovereigns this year. 

As central banks remove stimulus, asymmetric risks are likely to redefine asset classes along fault lines of relative leverage and varying growth outlooks.

Investors will need to consider more deeply what constitutes quality growth and what is a safe asset as historical notions of safety may be mispriced and subject to adjustment. 

Robert Samson is senior portfolio manager, multi-asset at Nikko Asset Management