Bank of America Stumbles On A $51 Trillion Problem
At the end of June, the Institute of International Finance delivered a troubling verdict: in a period of so-called “coordinated growth”, total global debt (including financial) hit a new all time high of $217 trillion in 2017, over 327% of global GDP, and up $50 trillion over the past decade. Commenting then, we said “so much for Ray Dalio’s beautiful deleveraging, oh and for those economists who are still confused why r-star remains near 0%, the chart below has all the answers.”
Today, in a follow up analysis of this surge in global debt offset by stagnant economic growth, BofA’s Barnaby Martin writes that he finds “that as global debt has been mounting to more than $150 trillion (government, household and non-financials corporate debt), global GDP is just above $60 trillion.” His observation is shown in the self-explanatory chart below.
As a result, both the global economy and central banks are now held hostage by both the unprecedented stock of debt injected into capital markets over recent years to offset the financial crisis depression, and the record low interest rates associated with it.
As Martin writes, “the global fixed income market (as captured by the GFIM index) is now above the $51trillion mark“, which means that “more than $51 trillion at risk if rates vol spikes and yields move higher“ and adds that “amid a record amount of assets acquired by the central banks we have seen the global fixed income market growing to the largest size it has ever been.” This is shown in the left panel on the chart below, while the right side chart shows the accompanying housing bubble: “amid record low funding costs the housing market is also experiencing rapid price gains in some regions as prices are now higher than pre-GFC levels. All main housing markets (US, Europe, Japan and UK) are above the 2007 highs, propped-up by record low yield levels.”
As a consequence of the above, both sides of the global wealth effect are at risk: not only the wealth effect for the “1%” via equity prices, but also for the middle class, in the form of real estate , which is traditionally where global middle classes have parked the bulk of their net worth, and which is now in a bubble thanks to said record low interest rates.
Of course, central banks are all too aware of the risk that this record debt stock presents, and specifically, the threat of sudden, damaging spikes in interest rates cascading into overall volatility surges, which explains why, as BofA puts it, “central banks have been sellers of vol” through QE. Quote Martin:
QE programs around the globe have had a clear target: to reduce uncertainty and dampen market volatility. As we have highlighted before, every time the Fed embarked on the different phases of its QE programme, credit implied vols declined significantly (chart 6). On the other hand, during periods of no monetary easing or when the market started pricing the possibility of easing policy removal (tapering tantrum and the subsequent tapering phase) implied vols advanced (chart 6). Same happened in the case of the ECB: implied vols have re-priced lower post the announcements of the PSPP and the CSPP.
However, when both the Fed and the ECB attempted to communicate that these policies will have an end-date, implied vols repriced significantly higher. A good example is the market reaction post the May 2013 Bernanke’s mention of the idea of gradually reducing the Fed’s monetary expansion. The same reaction was seen back in October last year, when tapering fears hit Europe: implied vols moved higher over the following couple of months.
So on one hand there is the threat of central bank balance sheet normalization which may, at any moment, prompt a violent repricing of volatility. On the other, Barnaby writes that “our work shows that the majority of vol spikes over the past years have taken place during periods of geopolitical uncertainty. Since 2013 we have seen a number of vol spikes and most of them had been the result of rising geopolitical risk.”
In 2013 it was the Syrian crisis and in 2014 was the Russia–Ukraine conflict. In late 2015 it was the Paris terrorist attacks and in middle last year it was the UK referendum. Recently we find that rising risks on the Korean peninsula has pushed spreads and vols higher. Note that European credit spreads have been in a constant tightening momentum since the CSPP announcement in March last year, but have moved wider in the past month or so.
Needless to say, the persistent threat of “geopolitical risk” at this moment is close to the highest on record. Ironically, when considering all potential threats, BofA concludes that “the risk for credit spreads and volatility is only on the moderate side as central banks are becoming more cognisant that “uncertainty” anda volatility shock could be damaging for the world economy. Hawkish messages are followed by dovish ones to introduce a “low vol monetary policy normalisation”. This is keeping vols and spreads in check.”
Or, said otherwise, for all the bluster of normalization, central banks will immediately backtrack the moment there appears to be even a moment of “miscommunication” between the Fed and capital markets, i.e., either a rate spike, or a jump in vol, or any other form or unauthorized selling of assets.
The implication is, of course, dire: with central banks trapped, this would suggests that the current pattern of relentless debt growth will persist indefinitely – or at least until it can’t go on any more – leading to an exponential growth in the “financial” economy at the expense of the “real” one, until finally the former swamps the latter.
This observation, brings us back to an analysis made by Bain several years ago:
Looking beyond today’s market conditions, however, our analysis found that capital superabundance will continue to exert a dominant influence on investment patterns for years to come. Bain projects that the volume of total financial assets will rise by some 50%, from $600 trillion in 2010 to $900 trillion by 2020 (all figures are in US dollars at the 2010 price level and market foreign exchange rates), even as the world economy increases by $27 trillion over the same period.
As it has for more than the past two decades, the large volume of global financial assets will continue to sit on a small base of global GDP (totaling $90 trillion by 2020 versus $63 trillion in 2010). At that level, total capital will remain 10 times larger than the total global output of goods and services and three times bigger than the base of nonfinancial assets that help to generate that expanded world GDP.
Nearly $1 quadrillion in financial assets (excluding derivatives) covered by $90 billion in global GDP in just a few years? That, much more than even the abovementioned $51 trillion in non-financial debt, is not only a major problem: it is an unprecedented disaster just waiting to hit.