7 December 2019
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A warning to central banks

David Bassanese
23 January 2018

To paraphrase a former United States President, today’s investors seems to have nothing to fear but that lack of fear itself.  At least over the short-run, this is very encouraging – but a lack of fear can lead to complacency and a build-up in excess risk taking as the International Monetary Fund has recently pointed out.

Like a tightly wound spring, the greater we wind it up today the stronger the eventual recoil maybe when things start to unravel.

While most investors direct their concern to equity valuations, these risks are building most notably in the (corporate) bond market.  Indeed, it turns out traditional global bond indices – the type typically tracked by active fixed income managers and exchange traded funds (ETFs) - may not provide as much downside protection in the next equity bear market as one might expect. 

First the good news.

In its latest economic outlook, the IMF upgraded its global growth outlook, reflecting accelerating growth in Europe, Japan and emerging markets and the recently passed US tax cuts.  Critically, business investment across the global is starting to pick up – reflecting a tightening in labour markets – which could help boost still flagging productivity and give the global economic expansion extra momentum.

The IMF expects the global economy will grow by 3.9% in both 2018 and 2019 after growth of 3.7% in 2017.  That would mark the best global growth outcome since the 5.4% in 2010 and 4.3% in 2011, when the world was just emerging from the financial crisis.

US economic growth is expected to step up to 2.7% this year after reasonable 2.5% growth in 2017.  In the Euro-zone and Japan growth is expected to ease modestly, but remain relatively robust (relative to their potential) with growth of 2.2% and 1.2% respectively.  

Growth in emerging markets is expected to accelerate from 4.7% in 2017 to 4.9% this year – even though Chinese growth is expected to slow – helped by major turnarounds in India, South America and the Middle East/Africa.

In terms of equity markets, the corporate earnings outlook remains robust. And while price to earnings valuations are above average in many markets, they’re not that richly valued compared to the still very low level of bond yields.   

Low interest rates have been an elixir that has help the global economy and equity markets stage an impressive recovery in recent years.

But low interest rates have arguably had even stronger and more insidious effects in the bond market. For starters, with central banks buying up government bonds and keeping interest rates quite low, corporate borrowing has exploded – enabling companies to leverage up and buy back shares (helping boost earnings per share growth) and also satisfy investor’s thirst for yield. 

In the United States, this has seen leverage ratios among major listed companies rise to near record levels.


Associated with this debt boom, the weighting of lower investment grade (e.g. BBB rated) corporate bonds in traditional bond indices tracked my both active and passive bond fund managers has increased.  Given these bonds tend to be less liquid in a financial crunch than government bonds or more highly rated corporate bonds, it can add to liquidity risk come the next downturn. 


Source: IMF

Around one fifth of the Bloomberg Global Aggregate Bond Index, for example, is now comprised of BBB rated corporate bonds. 

Another issue is the fact that emerging markets are, once again, being showered in cash. According to the IMF, non-resident inflows of portfolio capital into emerging markets may have reached around $300 billion last year, more than twice the total observed during 2015–16 and on par with the strong pace of inflows from 2010–14.  These strong flows into emerging market government and corporate bonds is probably one of the reasons the $US was surprisingly weak last year – to an extent the $US remains a ‘safe haven’ and so easily sold off as investors search for better yielding returns in riskier corners of the world.

Despite this debt build up, corporate and emerging market credit spreads remains very low – as would be expected given this has been a “demand” driven surge in bond issuance.

This is why central banks need to be very careful – but nonetheless resolute – in unwinding extreme monetary stimulus.  Their actions arguably helped the global economy get itself out of the last financial crisis, but if they’re not careful will help sow the seeds for the next one. 

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