Earlier this week, I said I’d look to see if there were any lurking signs of systemic stress in the global economy. After all, the collapse in price of the whole commodity complex must be causing problems somewhere, right?
Well, as far as I can tell, any issues — so far at least — are still localised. There are no signs that the volatility in emerging markets or commodities has made its way into the global financial ‘system’.
Not yet anyway. The thing is, traditional methods of looking for signs of systemic stress don’t really work in an era of QE and activist central banking. You have to look elsewhere.
For example, traditionally, signs of stress showed up in inter-bank lending rates. Inter what? I hear you ask.
Well, if there is a major problem in the economy it usually results in a bank, or banks, getting into trouble. This is how it happens…
At the end of each business day, banks with excess cash offer an overnight loan to banks with a cash deficit. The interest rate charged is the ‘interbank’ rate. The most well-known rate is the ‘LIBOR’, which is the ‘London interbank overnight rate.’ It’s the global benchmark.
If there are a number of banks that need cash to balance their books at the end of the day, the interbank rate will increase to reflect this shortage of cash. If this cash squeeze persists, or rumours start of a bank getting into serious trouble, the interbank rate will spike higher.
This is a sign that problems in the real economy have become ‘systemic’. That is, they’ve crept into the financial system. It’s exactly what happened in the lead up to the 2008 global crisis. Banks’ exposure to sub-prime debt saw interbank rates surge.
But now that global central banks have flooded the system with cash, there is plenty of it to go around. Having ample liquidity in the banking system means you need to see some pretty big problems before interbank rates rise.
Do you remember back in the days of the 2008 crisis the ‘TED spread’ was all the rage? No? Fair enough…
Anyway, the TED spread is, or at least was, a popular measure of systemic financial risk. It measures the ‘spread’, or difference, between LIBOR and US treasury bills, a proxy for risk free cash.
The higher the spread, the greater the risk in the banking system. It began rising sharply in late 2007 and went on to historic highs in late 2008, peaking at over 450 basis points. But now, the TED spread is quiet. It’s just 27 basis points, well within normal historical ranges. No sign of stress there.
Even China’s interbank rate, the ‘Shibor’, isn’t setting off any alarms, despite the multiple economic and financial problems being experienced in the Middle Kingdom.
In an age of nervous and ‘proactive’ central bankers, you shouldn’t necessarily take this as a sign that all is well. It’s just that traditional measures of stress don’t really work when the system is awash in central bank created cash.
In addition, we’re not at the height of a crazy global lending and house price bubble, where banks have massive exposure to a single and overvalued asset class. If you’re a reader of Cycles, Trends and Forecasts, you’ll know that we’re a few years away from the next property cycle peak.
The latest ructions in the global economy are of a more ‘macro’ nature. They’re the result of some very big picture forces. For example, the US dollar is in a major bull market. This is because the market thinks the Fed will increase interest rates soon.
A rising US dollar is a sign of contracting global liquidity. That’s why you’re seeing commodity prices tank and emerging market currencies hit decade-plus lows. It’s also why you’re seeing emerging markets’ foreign exchange reserves plunging. It’s all related to contracting liquidity in the ‘emerging’ world.
Banks are not traditional lenders to emerging markets or commodity producers, which is another reason why you’re not seeing traditional signs of major systemic stress right now.
Let’s have a look at the markets themselves though to see if there is any reason for concern. First there’s the ishares emerging markets index, as shown in the weekly, five-year chart below. The index declined sharply recently, and is now at its lowest point since mid-2013.
You can probably expect a rally soon, but a break below the June 2013 low would be a worrying sign. It would confirm that a long term downward trend is developing.
If this occurs, it would tell you that emerging markets, which make up about half of global economic growth, are entering a pretty nasty downturn. That in turn will put pressure on emerging market debt as governments target fiscal policy to offset the slowdown.
But right now, the broad emerging market government debt market doesn’t seem to be in any sort of trouble. The chart below, which shows the ishares JP Morgan emerging markets bond fund, is holding up very well. You want to see a break below the late 2014 low before getting too bearish on emerging market bonds.
So right now, you have to conclude that there are not too many signs of stress, although emerging market stocks do look a bit iffy.
While it would take time, the feedback loop from slower emerging market growth into developed economies will still occur. For example, US and European multinationals generate a lot of revenue from developed markets. A slowdown will hurt their profits.
The Financial Times reports on this very topic today:
‘Some of the world’s largest companies have sounded the alarm about the slowdown in the Chinese economy, warning that weaker growth would hit profits in the second half of the year.
‘Car companies such as PSA Peugeot Citroën, Audi and Ford have slashed growth forecasts while industrial goods groups such as Caterpillar and Siemens have all spoken out on the negative impact of China.
‘The warnings are a sign that China’s weaker growth and its stock market rout this month are creating a headache for global corporates that have long relied heavily on the world’s second-largest economy to drive revenues.’
And depending on the companies’ debt levels, a slowdown in revenues and profits could have a decent impact on the share price. But would it lead to a systemic crisis?
It’s impossible to tell. It really depends on the inter-linkages between emerging and developed markets’ banking systems. Right now there are no major signs of systemic stress. But if the US dollar continues to strengthen, which tightens global liquidity, then that could change.
So it’s ‘as you were’, but keep an eye on the exits.
For Markets and Money, Australia