In a report released this morning by the Organisation for Economic Cooperation and Development titled "Will risks derail the modest recovery? Financial vulnerabilities and policy risks" the OECD warns the global economy may not be strong enough to withstand risks from increased trade barriers, overblown stock markets or potential currency volatility, and adds that the "disconnect between financial markets and fundamentals, potential market volatility, financial vulnerabilities and policy uncertainties could derail the modest recovery."
The OECD projects global GDP growth to pick up modestly to 3½ per cent in 2018, from just under 3% in 2016, boosted by fiscal initiatives in the major economies, a forecast which is broadly unchanged since November 2016 and notes that while confidence has improved, "consumption, investment, trade and productivity are far from strong, with growth slow by past norms and higher inequality."
Furthermore, the OECD notes that the pace of growth will remain well short of its average in the two decades before the financial crisis because of weak investment and productivity gains.
“We have acceleration but I’m concerned about this really soft foundation to the recovery,” OECD Chief Economist Catherine Mann said in a Bloomberg interview. “We still have this slow, sluggish productivity growth and persistent inequality. Put those together and it’s hard to see the robust consumption and investment profile you need to really get things going.”
Taking a cue from the IMF and central banks, the OECD launched a veiled attack at Trump's proposed protectionist policies, and while the president was not named, the OECD highlighted concerns related to Trump administration policies, including his threats to impose tariffs on nations he deems to have an unfair advantage.
“We think the dynamic response to increased protectionism could be really quick, so we have a pretty significant downward bias on what it could mean for growth,” Mann said. “What we mean by that is the way businesses will respond by raising prices and cutting trade flows.”
Trump aside, however, key recurring core theme in the report is the OECD's warning that there is a notable “disconnect” between equity valuations and the outlook for the real economy, with the market performance partly linked to anticipation of a Trump stimulus package, to wit:
The positive assessment reflected in market valuations appears disconnected from real economy prospects. The interest-rate cycle turned in mid-2016 and rising divergence in interest rates between major economies heightens risks of exchange rate volatility. Vulnerabilities remain in some advanced economies from rapid house price increases. Risks to emerging market economies are high, including from higher corporate debt, rising non-performing loans and vulnerability to external shocks.
As Bloomberg notes, the OECD also highlighted potential exchange rate volatility from the shift in the interest-rate cycle. The U.S. Federal Reserve is forecast to increase interest rates next week in what may be the start of a series of hikes this year. In contrast, the European Central Bank is pressing on with its planned stimulus program through 2017. “Although risks may not materialize immediately, they remain a real possibility and a set of large shocks, possibly interacting with each other, would disrupt the recovery,” the OECD said.
Disconnects, volatility, financial vulnerabilities and policy uncertainty could derail the projected modest pick-up in growth. While immediate indicators of financial market stress have generally moderated compared with a year ago, underlying tensions have continued to rise. Although risks may not materialise immediately, they remain a real possibility and a set of large shocks, possibly interacting with each other, would disrupt the recovery.
Another warning: rising rates which could lead to "wider financial instability."
The recent interest rate rises have been associated with sizeable exchange rate movements, with the US dollar appreciating rapidly against the euro and yen, and a number of emerging market currencies have faced market pressures. Financial market expectations imply that a large divergence in short-term interest rates between the major advanced economies will open up in the coming years. This raises the risk of financial market tensions and volatility, notably in exchange rates, which could lead to wider financial instability.
The OECD also slams the world's overrliance on monetary policy, which has not only led to exceptionally low rates, but also rising debt levels, and elevated asset prices. In short central banks have created asset bubbles.
Significant financial vulnerabilities arise from the overreliance on monetary policy in recent years, which has led to an extended period of exceptionally low interest rates, rising debt levels in some countries, elevated asset prices and a search for yield. In advanced economies, some countries have experienced rapid house price increases in recent years, including Australia, Canada, Sweden and the United Kingdom. As past experience has shown, a rapid rise of house prices can be a precursor of an economic downturn. House price-to-rent ratios are at record highs in several countries and above long-term averages in many others. Although there has been a slower accumulation of household debt in recent years, mortgage-debt-to-income ratios remain high in many countries
Another major concern to the OECD are emerging markets, which are a source of "significant global financial vulnerabilities stem from emerging market economies, although the sources of potential vulnerability differ across economies." Of note here: China.
The rapid growth of private sector credit and the relatively high level of indebtedness by historic norms is a key risk in some countries, notably China, fuelled by favourable financial conditions amid low global interest rates. These high debt burdens, particularly of non-financial companies, leave economies more exposed to a rapid rise in interest rates or unfavourable demand developments. At the same time, a turning of the credit cycle is leading to a rise in non-performing loans, particularly for India and Russia, potentially exposing a misallocation of capital during the upswing and creating pressures on the banking system. In China, the high share of non-performing and “special-mention” loans reflects to a large extent borrowing by state-owned enterprises.
The OECD continues:
Many emerging market economies are also vulnerable to external shocks and currency mismatches. Sharp movements in foreign interest rates, rapid depreciations of the domestic currency, and or rising risk premia can induce financial stresses in countries with high levels of overseas borrowing or those with a mismatch between foreign currency denominated debts and export revenues. While exposure should take into account the position at the firm level and natural hedges and other factors, Brazil, Indonesia, Russia and Turkey have aggregate US dollar liabilities in excess of their estimated annual US dollar export revenues. While a number of factors make emerging market economies as a whole more resilient than during past episodes of rising interest rates in advanced economies, such as higher foreign exchange reserves and changes in the structure of foreign borrowing, exposures to global volatility are nevertheless high in many countries
A favorite topic of ours: the record low VIX which makes no sense in light of nre record high policy uncertainty. As the OECD wrties, uncertainties in many countries about future policy actions and the direction of politics are high. News-based measures indicate global policy uncertainty increased significantly in 2016, rising particularly sharply in some countries. Many countries have new governments, face elections this year, or rely on coalition or minority governments. More generally, falling trust in national governments and lower confidence by voters in the political systems of many countries can make it more difficult for governments to pursue and sustain the policy agenda required to achieve strong and inclusive growth. Rising inequality and growing concern about the fairness of society may also help to undermine trust and confidence in governments. These tensions lead to less predictable outcomes, including on progress in implementing policy reforms.
“Falling trust in national governments and lower confidence by voters in the political systems of many countries can make it more difficult for governments to pursue and sustain the policy agenda required to achieve strong and inclusive growth,” the OECD said.
There are many more warnings in the full report, but we are confident the market will do what it does best - ignore them - until the selling avalanche begins at which point the question will be "why did nobody warn us?"