Dormant systemic risk, buoyant geopolitical risk

Geopolitical risks for 2019

Yves Bonzon (Julius Baer) | Some investors and market commentators have interpreted the recent and persistent tensions in overnight repo markets in the US as a potential early warning signal of trouble. They draw parallels with the early warnings in credit market in 2007 right before the Great Financial Crisis. The current situation could actually not be more different: same symptoms, but very different cause.

This time, overnight funding stress is driven by an unfortunate combination of high quality liquid assets scarcity unintentionally caused by QT (Quantitative Tightening has reduced excess bank reserves at the Fed) and much stricter liquidity rules for banks by the regulator. The Fed knows exactly how to remedy the situation, either by loosening liquidity rules or by expanding its balance sheet. The problem is that the US Central Bank is not willing to do either of the two and the imbalance persists. This is in no way indicative of rising systemic risk though.

The global manufacturing recession has continued. It is first and foremost the result of persistent political issues such as the Sino-US trade conflict and the unresolved Brexit saga. In view of these uncertainties, corporate sentiment has suffered, affecting corporate investments. The slowdown has finally spread to the US where the ISM Manufacturing Index has declined below 50, signalling contraction. Encouragingly, some other forward-looking indicators, such as new orders and money supply, show signs of bottoming out. In contrast to the industrial sector, the relevant gauges for the services sector have remained in expansionary territory even though the dynamic has also eased. This reflects continued robust labour market conditions, which support consumer spending. Overall, global recession risks might have increased but are still contained. The lack of fiscal impulses across regions remains the biggest constraint on global activity.

Geopolitical issues

The signals ahead of this month’s Sino-US trade negotiations have been mixed. The outcome of the negotiations is hard to predict, as always. As outlined before, we have to bear in mind that the trade conflict is a symptom of a long lasting rivalry. Even if a trade truce or some sort of agreement is achieved, which would be in the best interest of Donald Trump ahead of next year’s US Presidential election, the relationship is likely to remain fragile. Meanwhile, the European economy is faced with another drag on business sentiment, the threat of a no-deal Brexit on 31 October. UK Prime Minister Boris Johnson has repeatedly said that he wants to leave the EU on that date with or without a deal. While a deal or an extension of the deadline appears to be more likely than a no-deal, the uncertainties persist for now.