• The global economic upswing is expected to remain in place for now which is good news for growth assets.
• But there are still plenty of downside risks to the growth outlook. We explore five key areas we are watching.

Introduction

We remain positive around the outlook for the global economy over the next year. But there are still numerous downside risks to growth that could cause issues for individual economies and spread globally, as well as impacting share markets. We outline our top five global risks to monitor in this Econosights.

Lack of progress in Euro area reforms

The Eurozone economy has enjoyed a strong cyclical rebound over the past year, with a clear convergence in growth across countries. Structurally, the Euro area also looks more stable, with an improvement in government debt, current account deficits and unemployment rates. Positivity around the future of the Euro area was further elevated with the election of pro-EU President Macron in France who campaigned for centralised reforms to strengthen the Euro bloc. But, there have been some recent setbacks which may delay any type of broad Euro reform.

Firstly, the new German coalition government (between Merkel’s Christian Democrats and the Social Democrats) have proved to be more fiscally conservative than anticipated and less willing to cooperate with Macron’s proposals. The second setback is the outcome of the Italian election, which has resulted in a coalition government between the populist parties of the far-right Northern League and the left-learning Five Star Movement. Both parties lean towards Euroscepticism and current proposed policies include a roll back of pension reform, income tax cuts and a modification of EU fiscal rules which are negative for the Italian economy in the long-run. Inherent Euroscepticism evident in both parties is a longer-run risk that needs to be monitored. For now, there are no signs that the government is planning to hold a referendum on EU membership.

Euro leaders meet in late June to discuss key issues around Euro reforms including changes to the European Stability Mechanism (scheme designed to help indebted countries), a Euro deposit insurance scheme to protect bank deposits and providing more funds for failed banks. Expectations around agreement on these issues are low which is disappointing because the strength in the Euro economy now means that reforms should be done sooner rather than later. Reforms are important to increase potential growth and sustainability of the Euro area. The risk is that reforms are delayed too far into the future at a time when growth is slowing. There is clearly more that needs to be done to lift household sentiment, with trust in EU institutions low (see chart below). But, households still have more trust in EU institutions, compared to national counterparts.

Source: Eurobarometer, AMP Capital

US debt build-up part 1

In history, economic expansions and an easing in interest rates have tended to lead to an excess of debt across sectors. These excesses later cause problems when economic growth starts to slow. In the US, years of low interest rates have contributed to some lift in corporate debt (still below pre-GFC levels) while household debt growth has been lower (see chart below).

Source: FRED database, Reuters, AMP Capital

US corporate spreads are very tight, reflecting the “search for yield” environment. Investors are probably too complacent around future risks in the corporate sector, particularly as debt and leverage has been rising. So far, the strong growth in the US economy (particularly in profits) has been providing good support for balance sheets and cash flows. But, once the momentum in earnings slows (probably towards the end of the year), investors may start to price in risks in the corporate sector.

Lending standards are something to watch. Conditions for large and medium firms are still loose (see chart below) and are around neutral for small firms which means that lenders are not concerned about credit conditions yet, as lending standards tend to tighten when it is clear that credit quality is deteriorating.

Source: Federal Reserve Bank, AMP Capital

Household debt levels are still under check and well below pre-financial crisis levels. The most significant rises in household debt have been in student and car loans (these are still relatively small as a proportion of total debt). But delinquencies are still broadly low. One area of rising delinquencies has been in credit cards which needs to be watched. Credit standards for mortgages are still solid. Signs of credit stresses may become more evident once the Federal Reserve lifts interest rates more this year. Rising wages growth will provide some offset.

US debt build up part 2

Besides household and corporate debt, US government debt is set to balloon and this higher debt needs to be funded by the rest of the world. The US government budget deficit will expand over the next few years because of the large tax stimulus package passed in late 2017 and the lift in government spending caps earlier this year. The additional government spending will put pressure on the budget deficit, which is headed towards 5% of GDP (see chart below) over the next few years, from 3% currently. Stronger economic growth will provide some offset to the lift in spending through rising government revenues.

Source: Reuters, FRED, AMP Capital

Lending standards and Australian home prices

While the Reserve Bank of Australia has kept interest rates unchanged for the past 21 months, increased prudential regulation has resulted in tighter lending standards and higher interest rates for some borrowers. And there is more to go. The Australian Prudential Regulation Authority has authorised lenders to increase the focus on household’s income and expenses for loan assessments. More regulation is also likely following the Financial Services Royal Commission. The tightening in lending standards is occurring at a time when home prices are already trending down, as supply increases and high prices pressure affordability. A focus on lending standards could mean that borrowers may receive less credit, but it also means that there may be less people who are eligible for a home loan. Ultimately, more stringent lending standards are positive for financial stability in the long-run, but in the short-term, these developments in the housing market may exacerbate downside home price growth as credit growth eases (see chart below).

Source: CoreLogic, RBA, AMP Capital

Higher commodity prices and inflation concerns

The global economic upswing is lifting inflation, particularly in the US where spare capacity is declining. So far, this lift in prices has been slow which has allowed central banks to keep interest rates low. But, recent surges in commodity prices (particularly in oil prices but also across other commodities like base metals) will lift prices in the near-term. Higher commodity prices are a sign of strong global growth but also reflect supply issues and geopolitical risks (in oil markets). The risk is that surging oil prices (currently above $75/barrel from mid-$60s in April for Brent crude oil) will continue for longer than anticipated, causing a spike in inflation which is a downside risk for global growth as the negatives for consumer spending and profits are more than offset by the benefits of higher prices for oil-producing nations.

Source: Bloomberg, Reuters, RBA, AMP Capital

Implications for investors

The strong global backdrop is positive for risk assets. But the five risks highlighted should be watched as a warning sign of a deterioration in global conditions.

About the Author

Diana Mousina is a Senior Economist within the Investment Strategy and Dynamic Markets team at AMP Capital. Diana’s responsibilities include providing economic and macro investment analysis and contributing to the performance of the dynamic markets fund.

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