Will Hobbs, head of investment strategy at Barclays Smart Investor, gives us a fright:
Equity and bond markets have been increasingly volatile in recent weeks as investors have reacted to rising US interest rates, concerns about the escalating trade war between the US and China, and the ongoing Brexit rumblings.
Much of the falls in equity markets in particular are so far down to little more than speculation, with company results remaining broadly robust across many sectors, but jitters are nonetheless turning into something more meaningful as losses start to accumulate.
Are we at the end of the cycle of losses, or the start of something more terrifying such as a sustained downturn?
Time will tell, but there are some potential events which are looming large in investors’ minds. Below Will Hobbs, head of investment strategy at Barclays Smart Investor, looks at three potentially ghastly scenarios which could panic investors.
- Global debt binge strikes back (again)
This continues to be the favourite choice of prospective economic apocalypse among doom-mongers – the one that perhaps speaks most seductively to our inner puritan. As measured by global gross debt as a percentage of GDP, the excesses of 2007 represent just a staging post to our current state of bloated excess.
The nightmare: Most asset prices seem crazily reliant on central bank largesse, the band aid which has allowed us to forget that the modern global economy is little more than a debt based confidence trick. As those same central bankers try to remove their atrophied patients from the monetary drip – as we are seeing in the US right now – this trick could be cruelly exposed, causing equity markets in particular to plunge as part of a long deferred mean-reversion trend.
The reality: But what if the personal perspective on debt was near irrelevant to how we should think about it at the global or even country level? What if the Great Financial Crisis actually had less to do with aggregate levels of debt and solvency, but rather liquidity – a sudden vacuum of confidence in a system that has always been reliant on it – even before we cast our monetary system adrift from gold?
We also need to remember that debt is also wealth – one person’s liability is another’s asset. Mortgage debt is an asset for banks; government bonds are held in your pension; debt issued by companies is financed by investors and banks.
We, the consumers, own shares in many of these institutions and even have a claim on government given that it is funded by our taxes. This points to the fact that at the global level, there can be no net debt, at least not until we manage to find any willing extraterrestrial suckers/creditors. The gross amount of debt owed by the global economy is therefore meaningless in isolation, in spite of the horror it generally provokes.
Furthermore, the ‘choke’ point for US interest rates for either the US economy or indeed the wider world in aggregate still looks to be some distance from current levels on our estimation.
- Break up of Europe
The nightmare: This is a recurring theme of the still smouldering eurozone crisis. Most recently it is populist Italian politicians who are the likely agents of the breakup, but before that it was mooted to be the UK’s referendum vote, the Greeks and various other discontented members. If there was to be a break up, it would likely be an economically savage event for the world economy.
The reality: Of course we could never rule out the breakup of the euro. However, investors should not underestimate the weight of history and, in reality, the lack of credible alternatives to further integration.
If the crisis of the last few years has taught us anything, it is that the major actors within the euro, from the German and French politicians to the European Central Bank, are more formidably committed to keeping the euro together than many might have previously imagined.
Besides which, Italian households hold assets worth several times’ the value of the debt the Italian government owes, which represents a very strong reason not to devalue both by returning to the lira.
- China collapse
The nightmare: A so called ‘hard landing’ for the Chinese economy has long been fetishised by Western commentators and certain very vocal hedge fund managers. A soaring debt pile, a wobbly housing market and a Western commentariat scarred by their collective failure to spot the troubles that lay in the US sub-prime sector are all contributing factors.
The reality: Again, it is impossible to totally rule out, however, as investors we are always trying to work in probabilities. How likely is it? For their part, Chinese policymakers have been introducing a range of regulatory reforms designed to reduce economy-wide leverage and curb financial stability risks.
These have had the side effect of tightening liquidity and reducing credit availability, leading to the current slowdown in the economy. With Chinese equities making up the largest component of our emerging market equity exposure, and the Chinese economy being a key source of external demand for the wider emerging Asia region, a more serious downturn would be particularly detrimental to our investment portfolios.
So far, we believe policymakers have sufficient controls over key levers of the economy to prevent an over-tightening scenario – recent actions pay testament to that. The ongoing slowdown has therefore been gradual, and the risk of it metastasizing into a more serious downturn remains low.
