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The world is not yet fully out of the aftermath of the 2007-2008 financial crisis, when the question is already raised on the risk of another crisis. The question is whether it is possible to move from a regime of growth without inflation and with low rates to one of higher volatility, inflation and interest rates without a financial crisis or any macro-economic shock... Such are the stakes for 2018. The excessively low bond yields, the credit bubble in China or the so-called “excessive” valuation of some equity markets are generally referred to as risky segments, while a badly perceived monetary policy decision or a sudden rise in inflation expectations appear as the most credible crisis-triggering factors, via a repricing of risk premiums. Do not underestimate the crisis-accelerating factors, currently significant, that are potentially the low liquidity of the fixed income markets, the concentration of the positions and the mimicry of investors. However, it is very difficult to bet on a major financial crisis, such as the ones that prevailed in 2000 or 2008. Among the reassuring criteria are the good health of banks, a favourable macroeconomic situation, economies with lower sensitivity to inflation than before, and central banks still credible, predictable, good communicators.
The scenario that seems most likely for 2018 is not a crisis scenario, but rather more nervousness. The market context has indeed evolved. Interest rate policies have reached their limit, the “ era of low interest rates forever” is over, the great period of disinflation has ended, and QE programmes will gradually disappear... All this means that the repricing of risk premiums will inevitably result in phases of greater volatility, short and long-term interest rates increases, wider credit spreads, and no doubt regular shocks in the equity markets.
The world is not yet completely out of the 2007-2008 financial crisis, but the risk of a new crisis already arises. The theme of “regime shift” (volatility, interest rate, inflation, etc.) has resurfaced, which led to a marked correction in financial markets in January – February. With sudden change in regime, the traditional ingredient of a financial crisis is excess liquidity that leads to a credit bubble: the stock and the evolution of private debt (in particular China) and public debt, as well as the low deleveraging since the 2008 crisis remain a concern. Economic history also teaches that financial crises are seldom anticipated, or more precisely, it teaches us that measures to avoid them are never taken in time.
In reality, crises have all been preceded by often very clear signals, but they have been ignored or underestimated (by regulators, by central banks, investors...). Who really thought in the 1990’s that the tech bubble would not eventually burst? Who really believed that the continuing overhang would not create strong economic and financial turmoil in the 1990s? How seriously consider that subprimes and abnormal risk aversion would not turn into deep problems in the middle of the 2000s? As a CEO of a big US bank ironically mentioned as an excuse following the crisis, “as long as music played, we all kept dancing”. Similarly, who still believes that the regime of low volatility, low inflation, low rates and excessive valuation of assets can last indefinitely? In other words, to see financial markets change, once again, constitutes a real threat.
Two types of “crises” should be highlighted: market shocks (for example, 10% drop) are frequent and most generally salutary, because they allow ‘purge’ excess positions, or correct excess valuations. These corrections are not alarming for the continuity of the regime. Financial crises, on the other hand, often represent real questioning of the existing regime, or even the overall functioning of financial markets and the economy (they are also seen as crises of capitalism and its excesses). Financial crisis usually follow periods of excessive valuations or, even worse, bubbles.
The question is whether it is possible to move from a growth regime without inflation and at low interest rates to one of (even moderately) higher volatility and inflation and higher interest rates without a financial crisis or a macro-economic shock ... that’s the whole issue of 2018.
Where do bubbles come from?
The factors that can develop (and burst) excessive bubbles/valuations are quite well identified:
Are there markets at risk?
Rightly or wrongly, according to usual comments, three markets may trigger a major shock or a crisis:
Crisis triggering factors vs crisis- accelerating factors
Within markets suddenly bearish and affected by fire sales, we must not confuse crisis triggering factors (change of monetary policy stance, geopolitical shock...) and crisis-accelerating factors such as mimesis (reversals of portfolio positions when they are all positioned in the same direction), concentration or the low liquidity... 1994 recalls that there is no need for a significant shock to cause a market drop or even a real crash.
What would trigger the next crisis (if any)?
Several factors are likely to play this role.
With rare exceptions, contagion effects are inevitable
The magnitude of contagion is mainly linked to economic and financial globalisation, but also to the nature of the crisis. If it concerns a country or zone, and if non-residents have invested little in that country or zone, then contagion remains low. A “simple” repricing of risk premiums, resulting in a moderate rise in interest rates would be less damaging to the real spheres, as interest rates would remain objectively low at the end. But the question of the impact of the financial sphere on the real sphere has always to be raised.
Are we ready to confront a crisis?
The capacity to cope with an eventual financial crisis can be assessed against several criteria.
Three scenarios at play
Scenario # 1: 2018, another year of “great moderation”, with low(er) volatility, stability of growth and inflation, low(er) inflation and low(er) interest rates (probability: 10%)
Scenario # 2: 2018, a year of higher volatility, with regularly hectic financial markets (probability: 75%)
However, the market environment has changed: (i) conventional monetary policies (interest rate policies) have reached their end... and “the era of low rates forever is over”, (ii) the great period of disinflation is finished; (iii) unconventional monetary policy (QE) programmes fade slowly. All of this means that the “repricing” of risk premia will inevitably lead to periods of greater volatility, with higher short and long term interest rates, wider credit spreads, and no doubt of regular shocks in equity markets.
Scenario # 3: a major crisis year (probability: 15%)
This section develops our central scenario and our main convictions. It highlights the main orientationsos our asset allocation and presents the strategies that characterize the structure of our portfolios: bond portfolios, equity portfolios and diversified portfolios.
Global Head of Research
Global economic conditions are benign thanks to a highly accommodative monetary and financial environment while trade multipliers magnified the re-synchronisation of the global cycle, the recovery in global investments and corporate profits (and specifically EPS momentum). The weak relationship between growth and inflation marks this cycle as unique.
Didier BOROWSKI, Philippe ITHURBIDE