Assessing Global Financial Stability
IMF News, January 24, 2019
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- Published: January 24, 2019
Overview & Context
- Remarks by Tobias Adrian, Financial Counsellor and Director of the International Monetary Fund’s Monetary and Capital Markets Department, OMFIF, New York, January 24, 2019.
- Global economic growth "has remained strong" but "the risk of a decline in global growth has increased."
- IMF will publish the next edition of the Global Financial Stability Report at the Spring Meetings in April.
Recent Market Developments
- Global financial conditions tightened appreciably in the last few months, with a significant global selloff in many major financial markets in Q4 2018.
- Partial retracement in early 2019:
- equities "making up about half of their 2018 losses";
- credit spreads "tighter by about one-third".
- 2018 described as "the most difficult year for markets since the global financial crisis"; almost every asset class saw negative returns except "safe haven" assets (US Treasuries, UK gilts, Japanese Government Bonds).
- 2018 saw a return of significant volatility; the VIX index "saw several spikes" during the year.
Growth at Risk (modeling insights)
- IMF’s "Growth at Risk" approach projects distributions of possible growth outcomes and focuses on adverse "left tail" scenarios with a 5 percent likelihood of occurring.
- Model run for the United States indicates risks to U.S. growth "have increased somewhat" and "the distribution has moved slightly to the left compared to the third quarter of 2018," even after market retracement.
- The Growth at Risk framework was first introduced in the October 2017 edition of the Global Financial Stability Report.
Inflation, Expectations, and Monetary Policy
- Negative data surprises in 2018 and pessimistic corporate forward guidance led to lower market expectations for inflation.
- Inflation swaps indicate markets predict subdued inflation over the next five years in the United States and the euro area.
- Options on inflation swaps imply "little chance of U.S. or euro-area inflation hitting 3 percent for a full year, over the next five-year period."
- Market expectations versus policy guidance:
- Markets expect the Fed to stay "on hold" in 2019-20.
- Federal Open Market Committee "dot plot" median forecast: two hikes in 2019.
- For the ECB, markets predict the first hike in 18 months — up from 12 months as recently as October.
Corporate Credit, Nonbank Finance, and Vulnerabilities
- Late-cycle signals in the United States: flattened yield curve, compressed term premia and credit spreads, strong M&A activity, rising wage growth, and very low unemployment.
- Corporate credit concerns:
- Corporate debt levels have spiked in some countries since the global financial crisis and remained high in others.
- Increasing issuance of lower-rated debt with fewer covenants and investor protections.
- Probabilities of default from widely used models are very low despite much higher corporate debt, suggesting potential underpricing of credit risk.
- A "weak tail" of corporations with earnings barely covering interest costs could become vulnerable to default if earnings decline.
- Nonbank financial sector:
- The market for leveraged loans has grown significantly worldwide and, in the United States, is "now larger than the high-yield bond market."
- Collateralized Loan Obligations (CLOs) and loan mutual funds play a dominant role in leveraged loans.
- Private equity, hedge funds and pension funds have large footprints in nonbank lending.
- December 2018 was "the first month in a decade" with no issuance in the US high-yield market.
- Liquidity and maturity mismatches among asset managers are a significant concern; with banks unwilling to provide liquidity, investor redemptions could force asset sales and market dislocations.
- Much of the nonbank sector remains uncovered by macroprudential policies; many policy tools apply only to money-market funds rather than the wider set of investment funds.
Emerging Markets and China
- Emerging markets were affected by the market selloff: portfolio inflows fell and have only "come off their lows in recent weeks."
- Rising spreads and higher volatility have increased funding costs and reduced investor demand for emerging-market and frontier issuers.
- China:
- China is "front-and-center" with focus on economic health and tariff dispute with the United States.
- China’s stock market was the worst-performing major market in 2018 amid trade tensions and regulatory tightening; stocks with significant U.S. exposure were especially hard hit.
- Authorities introduced measures to ease conditions; funding costs did not fall appreciably initially; additional easing measures introduced this year led to local markets starting the year modestly positive.
- Rising correlation between Chinese stocks and other emerging-market equities since trade tensions flared in 2018.
- Stronger U.S. dollar is an area of vulnerability because emerging-market corporates increased dollar borrowing in recent years.
Europe and the Sovereign-Bank Nexus
- Brexit-related uncertainty remains very high; U.K. stocks have significantly underperformed global equities over the past few years.
- Volatility in sterling FX options has spiked; demand for protection against depreciation grows around key risk periods such as the run-up to Brexit.
- Sovereign-bank nexus risk: banks’ large holdings of home-country government bonds can trigger a negative feedback loop when markets worry about sovereign credit risk.
- Italy highlighted: budget standoff with the EU led to widened BTP/Bund spreads in summer 2018; Italian equities underperformed during periods of tension.
Policy Recommendations and Watch Items
- Authorities should explore a wider range of macroprudential measures to address vulnerabilities in the nonbank financial sector beyond tools that apply only to money-market funds.
- Monitor corporate credit quality closely, especially the "weak tail" of firms with marginal coverage of interest costs.
- Watch U.S. financial-cycle indicators for signs of late-cycle vulnerability and potential tightening effect on growth.
- Track inflation swap markets and options-implied inflation probabilities to assess market-implied paths for monetary policy.
- Continued surveillance of China and emerging-market funding conditions given potential spillovers from volatility and dollar strength.
- Pay attention to sovereign-bank linkages in Europe, notably where banks hold large amounts of domestic sovereign debt.
Summary and Outlook
- Global financial conditions tightened in Q4 2018 driven by correction in corporate valuations and adverse data surprises; partial retracement occurred in early 2019 but conditions are "still tighter on net."
- Key risks: additional weakening in economic activity; further tightening of financial conditions; trade policy concerns; and political risks (exemplified by Brexit).
- IMF will continue close monitoring of global financial trends ahead of the Spring Meetings in April when the next Global Financial Stability Report will be published.
Remarks by Tobias Adrian, Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department, January 24, 2019.