The global outlook: beware falling objects

The world economy has in the past few years undergone a dramatic shift. Chinese industrial growth – for decades 10 percent or higher – has declined nearly to nil. Global commodity prices have shifted from high to low. At the same time, the U.S. dollar has surged from low to high against most other currencies. Partly this latter surge has occurred in response to the expectation of rising U.S. interest rates; and partly in response to turmoil elsewhere (most recently, the Brexit vote).

When the world shifts in a way that is unfavorable, the first reaction of those adversely affected is to hang on for dear life. That tends to work for a while. Budgets can be cut; credit lines called upon.

But eventually, those hanging on by their fingertips tend to fall. Some jump, recognizing that the shift is irrevocable and hoping they might land somewhere soft. Others hang on until they lose their grip.

And thus, a few years into this dramatic shift, the world outlook is: beware falling objects.

What might fall as a result of this economic shift?

To answer that question, go back in time. We don’t have to go too far back: more or less this same shift occurred in the early 1980s (see chart). Commodity prices were high in the 1970s; in the 1980s they were low. U.S. real interest rates were low in the 70s; in the 1980s they were high. The US dollar (not shown) was weak in the 70s, and strong in 80s.

Global shift

The first objects to fall were the emerging markets (see chart; I first wrote about this issue in April of last year). First, countries that were dependent on oil and other commodity exports defaulted; then countries that were dependent on foreign credit defaulted, as money was attracted back to the U.S. by higher interest rates and the strong dollar.

Global shift 2

Throughout the 1980s, nearly 20 countries defaulted on their debts each year, including much of Latin America (Argentina, Bolivia, Brazil, Chile, Costa Rica, Dominican Republic, Ecuador, Haiti, Honduras, Mexico, Nicaragua…) as well as other major emerging-market debtors worldwide (Ghana, the Philippines, Sri Lanka, Turkey…).

The next major object to fall was the U.S. Savings and Loan (S&L) sector (see chart). “But the problem with the S&L’s was that they were badly regulated,” you might say.

Global shift 3

That is true, but there was also an economic reason for the S&L defaults. The S&L’s were locked into long-term mortgage loans at low rates (the S&L business model was simple: take deposits; lend for mortgages). As overall U.S. interest rates rose, S&L’s were forced to offer higher and higher interest rates on deposits in order to attract depositors’ funds. But the money coming in didn’t change: mostly, the S&L’s were still locked into low-rate twenty-year mortgages.

Pretty soon, the S&L’s were making losses – indeed, nearly the entire sector was making losses. The S&L’s hung on longer than many emerging markets, but by the middle of the 1980s there were nearly 100 national bank failures a year, eventually necessitating a huge government bailout.

That was then. Now that we are a few years into the current version of this economic shift, what objects can we expect to fall today?

* Emerging markets. To date, Venezuela has struggled most dramatically to avoid sovereign default; but according to Oxford Analytica, Mozambique may be the first to let go. Many other emerging markets face less dire circumstances but have still been hit hard, with Russia and Brazil still in deep recession.

* Energy companies. Financially secure energy firms will tend to cut back output while commodity prices are low, but debt-laden energy firms will continue producing until they go bust. For a growing number of firms, that threshold is fast approaching. Spreads on high-yield energy company bonds soared earlier this year; so did the proportion of energy companies in distress.

* Banks. It seems too soon for banks to be hit again, but life isn’t fair. Some banks, especially in the U.S., have significant exposure to energy companies; indeed, research by Oxford Economics suggests that banks may be tightening lending standards in response to rising high-yield spreads, putting U.S. growth at risk. Banks in Europe, meanwhile, are struggling in part as a result of low interest rates, as the current drama over Italy’s banks reminds us.

The current global shift is only the latest in a long line of transitions that have seen business cycles become increasingly globalized. This trend began with the long boom of the 2000’s, driven by China’s soaring industrial demand for commodities and U.S. and European credit bubbles. It continued with the globally-coordinated downturn that followed the global financial crisis.

The downside of such globally-coordinated cycles is that when a cycle turns against you, there is nowhere to hide, and that everyone in an affected sector tends to fail at once. In the cycle of the 1980s, it took a few years for adversely impacted countries and companies to lose their grip – but when they did fall, they fell in great numbers.

With luck, the current cycle will moderate. Commodity prices, for instance, have recently rebounded somewhat; spreads on high yield bonds have fallen accordingly.

If not – if the current cycle lasts for a decade, as was the case in the 1980s – expect the trickle of falling objects to become a deluge.

Data sources: Oxford Economics, Oxford Analytica, IMF, World Bank, Bank of Canada, the U.S. Federal Reserve, and Buschmann, Christian Friedrich, “Sovereign Risk: Characteristics, History and a Review of Recent Research,” in Sam Wilkin, ed., Country and Political Risk: Practical Insights for Global Finance, Risk Books, 2015.