The Strategist

What risks threaten the world economy?

05/19/2016 - 16:21

Russ Certo of Brean Capital together with Bloomberg experts prepared a comprehensive analysis of the current market risks.

Their key takeaways reflect not only increasingly significant decline in the global capital market. They explain why investors are increasingly choosing to move away from risk, leaving central banks deal with each other.

Investors withdraw from the capital market due to extremely adverse prospects. Generally, the market becomes more confusing due to global assessment of uncertainties associated with monetary policy and political decisions taken in the financial crisis of 2007-2009. All this spirals into reduced trading volumes.

"Firstly, this is China, then Japan, then - the ECB. When the going gets though, speculators prefer to leave the game." - says Russ Certo, managing director at Brean Capital.

Major banks around the world are reducing volume of trade transactions in an effort to cut costs amid growing regulatory requirements.

"Investors are stewards of other people's money and are not willing to invest in pyramid schemes," - said the expert.

Speculators in China receded as quickly as they had moved in the volume of trades on the three major exchanges of the country, the volume of which is now almost half less compared to April 22nd.

Strategic risks

The main risk is that the global financial markets are more vulnerable to political shocks: stock indexes are near historic highs, yet yield of sovereign bonds is close to record lows.

Market participants are losing confidence; especially central banks make unexpected decisions. A good example for this is the case with the Central Bank of Japan, which was unable to increase monetary stimulus on 27 April.

The Fed risk: Fed assured markets that it will increase interest rates in the fragile world economy, or before market prices will start to rise. The first would depend on risky assets, while the second would create a negative shock.

The ECB risk: quantitative easing program is ineffective, as the current account and the excess liquidity are near record highs.

The risk of the Bank of Japan: Bank of Japan is losing control over the strengthening yen. The institution is still unable to promote growth or inflation, and is burdened by Abenomics’ fiscal policy, which remains inefficient.

Permanent risk "Basel III": all regulatory rules are still forcing commercial banks to hold liquid assets of higher quality, aggravating the liquidity deficit.

Political risks


Uncertainty overshadows Brexit’s possible impact on the markets, the British pound or the economic policy.

Half of the respondents in Belgium, France, Germany, Hungary, Italy, Poland, Spain and Sweden said that their countries should hold a referendum on the question of staying in the EU, according to the poll, conducted by Ipsos Mori, published on 9 May.

The survey shows that 40% of Britons would vote to remain in the EU, 41% - for having to leave the EU. A poll conducted last week showed that the correlation changed to 44% against 45%, respectively.

British Pound’s exchange rate, following the Brexit risk, may be significantly lower than current levels. Some analysts say that the pound’s strengthening is reflecting greater confidence in the fact that the British are in favor of staying in the EU. Meanwhile, others are warning that this may show a misunderstanding of recent opinion polls. 

Central and Eastern Europe may be the most vulnerable to the Brexit risk since Poland is the largest net recipient of EU funds, while the United Kingdom - the third largest net payer.

The EU’s tempest 

The risk that the EU will not able to stop the migrants flow is rapidly increasing. It contributes to the rising nationalistic pathos and internal strifes.

The growing risk for European financial systems of the regions is producing more and more problems. Increasing political uncertainty, growth of "bad" loans and economic slowdown are contributing in the danger, too.

Italy may fail to achieve the target of debt reducing; quality of bank assets continues to deteriorate, and Atlante fund is proving to be ineffective.

Greece may not fulfill terms of the agreement to reduce the debt burden. This would force the country to carry out another round of restructurings.

Elections on June 26 in Spain can create another stalemate, as there is a risk of emerging an anti-government coalition, intended to dismiss the Prime Minister Rajoy.

Hard landing of China's economy

There is an risk increasing that the Chinese economy could make a landing harder than expected. The herald of the Communist Party of China - People's Daily journal - said that China should set a goal of deleveraging the economy. This may affect the pace of economic growth.

China may lose control of deleveraging, which will aggrandize risks associated with increased volatility of the financial market and/or economic hard landing.

Also, China may lose control of the capital outflow, and will be forced to allow the renminbi to depreciate more quickly. Incidentally, Hong Kong imports rose by 204%, which reflects a significant outflow of capital.

The risk of selling reserves of China’s stock market continues. The reserves rose by $ 11 billion to $ 3.316 trillion, although this was mainly due to revaluation against the background of the falling dollar.

The intensity of futures trading on the Chinese commodity exchanges is slowing down. However, it is still one of the most liquid markets in the world.

Chinese companies operating in the metals and mining and coal industry, must return 239.6 billion yuan in the three months through June.

Oil prices

Low prices may continue to exert additional pressure on US oil companies. This would lead to more defaults that will provoke credit problems for small banks, private equity firms and hedge funds; it will increase the potential for downward pressure on other assets sold to cover losses.

At the upcoming summit in June, OPEC may not set limits on the oil production volume after the failed negotiations to freeze production last month, which led to another drop in oil prices.

Lower oil prices may force the Saudis to continue use the accumulated reserves in order to protect binding national currencies to the dollar. Reserve assets are $ 587 billion, compared with $ 745 billion in August 2014.