March, 2016 Archives

8
Mar

The 7 Big Risks Facing The Global Economy

by Riaan Nel in Global Economy

 

Tail risk

 

Recently Nouriel Roubini wrote an article about the 7 risks he sees that are plaguing the US and global economy.  I want to provide a summary of the article and share some of my thoughts about the issues he raises.  I agree with Roubini that we potentially might be entering an era of volatility that is more serious than anything since 2009.  There are currently seven sources of global “tail risk.”  Tails are the end portions of distribution curves represented by bell-shaped graphs showing the statistical probability of a measured event.

Risk 1: The slowdown in China.  According to Roubini China is more likely to have a bumpy landing as its economy is slowing down.  I agree that it seems like the policies the Chinese government have used to manage the process of a slowdown and to manage the restructuring of their economy from and export led model to a more domestic consumption based model, seems to be running out of steam.

Risk 2:  The emerging world is plagued by currency weakness which has the dangerous consequence of increasing the real value of trillions of dollars worth of debt these economies have built up over the last decade.  As a long term trend I continue to believe the emerging world will be one of the main engines of growth fueling the global economy in the future.  But currently these economies are in serious trouble.

Risk 3:  Roubini thinks the Fed erred when they increased interest rates in December 2015.  He sees tighter financial conditions via a stronger dollar, corrected stock market, and wider credit spreads that are threatening US growth.  He is, of course, right about the tighter financial conditions, and that remains a risk.  Although, I don’t think the Fed erred necessarily.

Risk 4:  Roubini points to many simmering geopolitical risks.  There are always geopolitical risks.  I don’t see anything currently that I would classify as a tail risk.  But his point about the uncertainty created by the prospect of a long term cold war between Sunni Saudi Arabia and Shia Iran is worth thinking about.

Risk 5:  Declining oil prices is definitely a major issue.  Although it is counter intuitive that cheaper energy should be a “risk,” it creates the following problems.  It damages US energy producers, which comprise a large share of the US stock market, it imposes credit losses on energy exporting economies and energy firms, and regulations restrict market makers from providing liquidity and absorbing market volatility.  So each shock becomes more severe in terms of risk-asset price corrections.

Risk 6:  Global banks are challenged by lower returns.  New financial technology is disrupting their business models and there are rising credit losses on bad assets (energy, commodities, emerging markets and fragile European corporate borrowers.)

Risk 7:  There are massive problems facing the Eurozone.  Roubini thinks the European Union could be ground zero for global financial turmoil this year.  Their banks are challenged, the migration crisis could end the Schengen Agreement (which represents a group of countries allowing the free movement of people), Britain might exit after their referendum in the summer, and Greece and its creditors are again butting heads.

I’ll end with this paragraph from Roubini:

“In the past, tail risks were more occasional, growth scares turned out to be just that, and the policy response was strong and effective, thereby keeping risk-off episodes brief and restoring asset prices to their previous highs…  Today, there are seven sources of potential global tail risk, and the global economy is moving from an anemic expansion to a slowdown, which will lead to a further reduction in the price of risky assets worldwide.”