In late June, the famed Bank for International Settlements produces their annual report for their financial year that ends at the end of March. The financial institution, based in Basel, Switzerland, is known for its international clientele and enduring history of excellent economic analysis. With 60 central banks included in its operations, the BIS has its hands in a group of nations that accounts for about 95 percent of the world's GDP. Hence, a report as extensive and in-depth as its annual publication is widely read and referenced among analysts. Its insights into monetary policy and the dynamics of the global economy are impressive. For that reason, I shall use the charts and graphs in the report to paint a picture of BIS's economic analysis as well as adding my own perspective along the way. Here is the global economy in charts.
All images and quotes can be found in this report.
"The global economy is not as weak as rhetoric suggests"
The media, analysts, and pundits covering economic news aren't told to sell lukewarm. Instead, public figures use extremes and decisive statements to polarize their arguments for the sake of joining the bulls or the bears. Too often, they ignore the average, a state that is the most probable. The BIS, though, successfully disables the extremes of both side with the statement, "the global economy is not as weak as rhetoric suggests." The report acknowledges the existence of weakness but admits that it might be more average than detrimental. The opening BIS statement is supported by these three charts which paint a picture of a stabilizing system that has just undergone a period of disequilibrium. GDP growth's variability reduced across countries, and now a trend of convergence is setting in. Unemployment in advanced economies (AEs) are finally regressing towards the mean while discontent in emerging economies (EMEs) have caused an uptick in recent jobless numbers. In the past six quarters, we've seen oil price fluctuations complicate economic growth in the post-crisis bull market, but those trepidations have largely calmed down. After peaks in 2015 and the first two months of 2016, the CBOE Volatility Index (VIX) is down over 30 percent this year. As fearful trading has subsided, investors with more confidence are buying back into the market. Suddenly, the Dow and S&P are setting new highs.
This interesting environment described by BIS's big picture diagnosis is best explained using the concepts of energy in physics. In mechanics, objects with mass always have energy. With movement and force, kinetic energy represents the amount of energy used to do work. For example, it takes kinetic energy to move a box from one location to the other, to start a car and drive across the country. But an object doesn't have to be moving to have energy. Potential energy is energy that an object with mass has based on its position. A ball on the top of a hill has potential energy because gravity can push it down the slope with the right catalyst. That picture of the ball might be an accurate image of the global economy at this moment. Volatility has slowed down, and a steady positive trend has taken over. Relative to stock movement in August 2015 and January 2016, markets have shown reduced kinetic energy, or volatility, which usually supports an optimistic environment. But, potential energy remains high. Stocks and bonds are tightly wound and give the impression that they could fall at any moment. The BIS points out a "risky trinity" that adds to this negative potential energy: "low productivity growth, global debt levels that are historically high, and narrow room for policy maneuver." BIS's opening statement should not be taken as assurance that weakness is gone; instead, investors should recognize this idyllic trading period as a short respite before the storm.
"...a highly visible and much-debated sign of this discomfort has been exceptionally and persistently low-interest rates"
Because the BIS has access to data and policy from over 60 central banks, its monetary commentary is some of the best in the game. In the low-interest rate environment, it has been quick to be critical of the loose policy that has whitewashed the capital markets in advanced and emerging economies. As the first chart demonstrates, policy rates in Japan, the euro area, and the United States (G3) have been forced into negative territory after adjusted for inflation. The central banks have maintained this policy in order to encourage investment in the equities markets and allow lending to occur at almost no cost to the borrower. As a result, households, governments, and businesses have stacked up on debt, and it has created unsustainable growth. The BIS condemns this trend saying, "debt has been acting as a political and social substitute for income growth for far too long." The global economy will not survive for long if market participants continue to support the imbalance of productivity and credit. Instead of a large-scale shifting of funds, the BIS encourages "an urgent rebalancing of policy to focus more on structural measures, on financial developments, and on the medium term." Policy changes seem easy enough, but complications could arise from the turbulent relationship between monetary and fiscal institutions as they often have before.
Another consequence of persistently low-interest rates is a topsy-turvy bond market with yields that discourage investment in that arena. The chart on the right catalogs some of the lowest yields in the world, and surprisingly, they have fallen below zero. Japan's yield has fallen to about -0.125 after its central bank began experiments with interest rates set at negative values. France, Denmark, and Sweden, the three lowest yields in the euro zone are results of low rates and heavy quantitative easing from Draghi's ECB. The BIS sees this as a signal that, "market participants look to the future with a degree of apprehension." Trust in monetary policy is quickly falling as inflation struggles to pick up and growth settles into a new, low "normal." The solution to global economic weakness will not come from the halls of major central banks, but instead, will be left to the whims of the crowd. Large-scale asset purchases have exhausted bond markets in advanced economies forcing money to chase riskier segments, a dynamic that would accelerate a crash if one were to come. In addition to this risk, unconventional adjustment of long-term interest rates will not be an option in the next downturn as they have already been flattened to dangerous levels.
"Global debt continues to rise and productivity growth to decline"
The above charts produced by the BIS go hand-in-hand with the four-part series just published on Black Gold Disease called Predicting a Crash. In it, I discussed the incredibly high levels of debt across every kind of economy. From 2007 to 2015, government, corporate, and household debt has been on a clear climb upward with AEs and EMEs all reporting debt that is over 150 percent of GDP. That growth might not be troubling if justified by a simultaneous increase in output, income, and consumption, but these characteristics of a healthy expansion are mostly absent. As evidenced by the chart on the left, labor productivity has remained below 2000-2005 levels even though a robust recovery after the financial crisis was supposed to take place. For that reason, these two issues are set as the first two pillars of BIS's "risky trinity." The truth is, employment supported by borrowed capital is not sustainable and has lead to a crowding out of growth that is sustainable. In the end, there will be a correction in one of these areas. Either productivity will see a robust recovery in the next few years, a positive growth scenario, or debt levels will be forced downwards, a catastrophic scenario that would lead to a crisis.
"The spotlight shone especially brightly on China, which for several years had been seen as the global growth engine"
The BIS identifies "the first episode of market turbulence" as the global sell-off in the third quarter of 2015 largely lead by weak Chinese fundamentals. Major market indices in China's equity markets revealed a relative trend of overvaluation as its people sought yield for its savings glut. The largest Asian nation is also known for its high savings rate which causes its domestic firms to be less reliant on domestic consumption. The chart on the right shows how prices and P/E valuations topped out in the middle of 2015. After the peaks, volatility set in as traders sold heavily before buying back into the trend. Currently, valuations are still higher than 2015 Q2 levels, but fundamentals such as manufacturing and GDP growth rate have stabilized countering uncertainty. Still, the BIS sees fragility in Chinese equities as the 2015 sell-off, "shook confidence in China’s ability to achieve a 'soft landing' scenario after years of rapid credit-fuelled growth." The Chinese government, which remains very exposed to debt in many advanced economies, might experience even more distress if a global credit crunch ensues. In the end, investors should never let their eyes stray far from this nation as its currency fluctuations (middle and left graph) and large demand have the power to sway the world's economy.
"The plunge in commodity prices weakened the economic prospects of commodity-exporting countries and of commodity-producing firms"
If there was one sector that lost in the 2015 year, it was energy. Since the second quarter of 2014, oil and gas firms have been grappling with the new trend of low oil prices. And while some institutions claimed that the fluctuations were temporary, Brent and WTI spot price movement is shaping up to reflect a lower-for-longer scenario. Oil and natural gas saw their prices drop by well over 50 percent, but they weren't alone. Metal and foodstuff saw similar debilitating movements on the futures markets, a cumulative effect that weighed on inflation. Deflationary pressures caused by these volatile commodity prices (middle chart) forced monetary institutions to be cautious in their policymaking, a sentiment not well received by market participants. We saw energy prices take a toll on market dynamics but they also played a role in an industrywide earnings loss. As illustrated by the graph on the right, energy stocks almost 50 percent in 2015 putting many of the weaker issuers in danger of bankruptcy. In fact, these companies played a large part in debt growth as, "their bonds
outstanding increased from $455 billion in 2006 to $1.4 trillion in 2014, or by 15% per year; and their syndicated loans rose from $600 billion to $1.6 trillion, 13% per year." The BIS and many other analysts blame this weak sector for the losses in the high yield sector, a segment of the market that is just now starting to rebound. Energy volatility has recently started to cool, and that will support investors looking to buy oil and gas producers at a cheaper price. But, oil prices don't appear to be increasing anytime soon. This could create imbalances in power among oil importing and oil exporting nations.
"The likelihood of divergent monetary policies between the United States, on the one hand, and the euro area and Japan, on the other, contributed to renewed dollar strength"
The BIS stresses monetary analysis in its report and provides excellent insight on how different policy affects each corner of the economy. In these charts, it looks at the performance of the dollar in relation to interest rate expectations in the euro zone, Japan, and the U.S. The Federal Reserve looked to be the most eager to raise rates as 2016 was once projected to have as many as five rate hikes occur. At the same time, the Bank of Japan and the ECD were both reluctant to raise rates in what they determined was a weak economic state. As the BIS comments, the diverse global economy experienced "uneven global momentum" as fluctuating commodity prices affected markets in different ways. This individualistic approach to cohesive monetary policy appears to have failed as the expansive setting that has been maintained since 2009 is failing to produce a positive effect. Investors are trading the uncertainty and division by flocking into the dollar, the currency in which most debt is denominated. This dynamic has weighed on the Federal Reserve's hopes for growth in foreign demand forcing them to be even more dovish. Investors have responded by selling more bonds and flattening the forward interest rate curve (right graph). Every meeting in the Fed, ECB, and the BOJ seems to be conducted on a tightrope as options are limited. The BIS cites this lack of flexibility as a problem that plagues economic stability and something that must be fixed if a crash is to be avoided.
The annual report of the Bank for International Settlements is a must-read document for investors who pay attention to macroeconomics. Its expertise on monetary policy and accessible charts allow investors the opportunity to discover many critical insights. The fragile state of the global economy demands an accurate analysis of the forces that underpin its movements, whether they be positive or negative. This publication provides many different perspectives looking at the problem of weakness in financial markets and could be the reason why you avoid losing big in the next crisis.