Is Global Recession On Its Way? Brexit May Be A Warning Sign...

June 17, 2016

Is Global Recession On Its Way? Brexit May Be A Warning Sign…

  • Global GDP growth rates are stalling even with increased monetary stimulus.
  • There are several potential recession triggers.
  • It is important to assess the risks a portfolio runs as no one can know when a recession will come, but eventually it will as it always has.

Introduction

The main FED goals are sustainable economic growth and full employment. In order to achieve those goals, the FED has decided not to increase interest rates as the economy is still relatively weak and employment has been slowing down. Not only that, but the expectation of future interest rate increases has been revised downwards.

This brings several consequences. In case of an economic downturn, which would be completely normal as we have not had one in the last 7 years, the FED has no maneuvering space left to help the economy as the interest rates are still at recession levels.

1 figure gdp to date
Figure 1: U.S. GDP growth to date. Source: Multpl.

As the last recession was 7 years ago and every economy is cyclical, we should not be surprised if a recession comes along. No one can know when this will happen as recessions always come unannounced, but we can take a look at the risks that can trigger a recession and the consequences of it.

Potential Recession Triggers

Brexit

A vote in favor of the U.K. to leave the EU might influence some longer term market disruptions as London is the European financial center. The U.S. Treasury Secretary recently issued a warning stating that the global economy would be damaged if the U.K. leaves. The recent polls show a scary shift toward a leave.

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Figure 2: Brexit polls. Source: Financial Times.

The ‘remain’ has always been greater than the ‘leave,’ but it seems that the undecided are turning toward a leave. Next week will be an interesting one as we will see the long awaited Brexit vote confirmed, be it a leave or a remain.

Another Bad Summer in China

Last summer we had the first meaningful stock market fall in the last 7 years as the Chinese stock market precipitated on weaker Chinese growth.

3 figure China GDP growth
Figure 3: Chinese GDP growth per quarter. Source: Trading Economics.

As China is increasing its debt levels in order to force economic growth, the long term perspective is one where if all goes well, China will have stable growth levels but any global shock like the above Brexit might influence further slowing down and a global deflation spiral.

4 figure china debt to gdp
Figure 4: Chinese debt to GDP. Source: Trading Economics.

Debt usually means trying to hold on to the status quo until there is liquidity. The above increases in Chinese GDP show that China is desperate to keep its growth rates as it might implode without high growth rates.

As China and all other economies are dependent on global trading, any indication of global isolation would quickly spur discomfort into the market and this brings us to the next possible trigger.

U.S. Isolationist Tones

Currently Clinton is ahead in the polls but the Brexit example shows how we cannot bet on polls. If Trump’s isolationist rhetoric is more than just election tactics this could have a severe impact on U.S. trade and global economics. History has proved that any kind of isolation is detrimental to economic growth and wellbeing, and the current high standard we are enjoying is a result of global integration increasing its speed in the last three decades.

Global Monetary Policies Imbalances

With the FED slowing down, this is less of a concern as the higher U.S. interest rates would have strengthened the dollar and lowered U.S. exports. Everything produced in the U.S. would have been more expensive and U.S. corporate earnings would have been lower in dollar amounts.

Countries like India or Brazil, where interest rates are relatively high, are still not such a big influence on the global economy, but an economic rebound or inflationary pressure in one of the global economic pillars like Europe or the U.S. would trigger worldwide financial instability.

5 figure global interest rates
Figure 5: Global interest rates are at historical minimums. Source: Trading Economics.

The event of such a situation is highly unlikely especially after the FED has slowed down with its interest rate plans and the situation in Europe is not indicating economic exuberance.

Europe

Europe is the next risk factor for global markets. Even if we haven’t had a ‘Greek’ moment or a bank crisis for a while as the European economy is growing, that growth is still not stellar and has already peaked.

6 figure EU growth
Figure 6: European GDP growth. Source: Trading Economics.

EU growth has reached 2% in 2015 but is already declining and sits at 1.8% currently. This is a good number for Europe as the 2012/2013 recession is not far away, but the growth is fueled by increased debt levels and the non-performing debt ratios are scary for EU banks.

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Figure 7: Non-performing debt ratios for EU banks. Source: European Central Bank.

For comparison, the average U.S. non-performing loans are at 1.67% which is much lower than the EU 7%.

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Figure 8: U.S. non-performing loans. Source: Statista.

Therefore, Europe not only has the ‘Brexit’ issue as a potential destabilizer but also bank fragility and the fragility of the whole economy.

Understanding of Risk

The last risk related to global markets is the assessment of risk investors have. With yields at historical lows, investors might be losing the perception of risk, especially as central banks run to save the markets as soon as any decline is anticipated.

A shift in the perception of risk might be the biggest risk of all as we have seen that after the FED decided to keep rates steady and lower for a longer period of time, the DOW index declined and did not, as usual, increase based on continued FED stimulus.

Conclusion

The scope of this article is not to be the chicken little but to objectively assess real risks to your portfolio. A recession would be catastrophic at this moment as central banks are out of firepower. Maybe they can keep markets at a permanent high level with low interest rates, but there are several structural and cyclical longer term forces that come into play here and cannot be influenced by monetary policy.

The U.S. is approaching full employment, corporate earnings and investments have been declining for a while even though interest rates are still low. As we already mentioned, we cannot know when any of the above described risks will kick in, maybe even next week with Brexit, or not in the next few years.

Eventually a recession will come, as it always does, unannounced and surprising, nobody knows when but it is good to think of how risky is your portfolio in relation to that and if maybe the same returns can be reached with less risk.