Another Lehman-Type Collapse Is The Biggest Threat We Face

Four days into 2016, you’ve no doubt read numerous “my predictions for the new year” columns. Read mine anyway – as some the economic viewpoints below will differ from those you’ve read elsewhere.

Starting on a consensual note, I agree with Christine Lagarde, the Managing Director of the International Monetary Fund, when she said last week that the stuttering global recovery will continue to be “disappointing” in 2016.

The world economy will expand 3.6pc this year, the IMF estimates, up from 3.2pc in 2015, but still below the 4.1pc annual average during the decade leading up to the 2008 financial crisis. That pre-Lehman growth, in turn, pales into comparison with the 1960s – when world trade was expanding rapidly, and the global economy surged 5.5pc a year.

The IMF is also right to highlight likely “spillover effects” this year from the first rise in US interest rates since 2006. There could, indeed, be a “failed normalization” of rates, with stock and bond markets reacting badly as some Western central banks begin the long march back from ultra-low borrowing costs. Financial turbulence could certainly wipe-out pc of global economic output by the end of 2017, as the Fund warned in its latest Financial Stability Report.

I don’t agree with IMF economists, though, that the main danger to the global financial system now stems from “companies across the emerging markets” that have apparently “over-borrowed by $3,000bn” since the mid-2000s. Such companies are clearly more indebted than in the late-1990s, the last time an “Eastern crisis” impacted the rest of the world. And higher US rates will, of course, increase the debt-service costs of dollar loans held by relatively young companies in countries like Turkey and China.

It’s also true that Brazil and Russia spent much of 2015 in recession and will continue to struggle amidst relatively low commodity prices in 2016. Having said that, both have very low levels of government debt – around 10pc and 60pc of annual GDP respectively – compared to 80-100pc in many developed countries.

Emerging market central banks have also considerable increased their foreign exchange reserves since the late-1990s, from 12pc to almost 40pc of national income on average, according to the Bank of International Settlements. Such nations now control three-quarters of reserves across the world – which is why the West borrows so heavily from them.

The greatest danger to global financial stability lies not in emerging market corporate indebtedness, but elsewhere. Across the US, UK and the Eurozone, our big banks, still largely unreformed since the last Western-derived financial crisis in 2008, remain too-big-to-fail. With interest rates already at rock-bottom and government bond markets propped-up by virtually printed money, the “advanced countries” are actually pretty vulnerable position if we do see “another Lehman”.

I’m not saying there will be a financial crisis in 2016. I certainly hope there won’t. But I know plenty of highly-experienced Western investors now sitting on the sidelines due to deep concerns the “post-Lehman” story isn’t over. I would also venture that if we are to endure a “systemic moment” over the next 12 months, it’s more likely to derive from the eurozone and/or a more general realization that quantitative easing, on the scale we’ve pursued it, is counterproductive, than from any particular country in Asia, Eastern Europe or Latin America.

The IMF disagrees. Lagarde warns the emerging markets are “dangerous” and the actions of their ambitious, fast-growing companies could “infect” Western markets. As a result, the argument goes, the European Central Bank and Bank of Japan need to keep printing and, despite widespread doubts among serious people, the IMF says that’s OK. Such a narrative strikes me more as alibi-creation and preemptive finger-pointing than serious, financial analysis. We shall see.

In terms of concrete predictions closer to home, I don’t think the Bank of England will follow the Federal Reserve and raise interest rates this year. Britain and America expanded at similar rates during 2015 – 2.4pc and 2.5pc respectively – and have comparable unemployment (around 5pc). Yet UK fiscal policy is tighter and our pay growth remains subdued (in part due to high immigration). Both factors make a UK rate rise less likely – as does the trend of credit growth, which remains far less expansionary here than in the US.

The Bank could be forced to raise rates sooner, though, if our huge external deficit weighs on the pound and oil bounces back, causing inflation to spike. The current account shortfall for 2015 will come in at around 4pc of GDP, by far the worst in the G7 group of leading economies, driven not only by far fewer exports than imports but a very sharp fall in investment income from abroad.

Such macro imbalances tend not to matter, until market sentiment shifts and then, suddenly, they matter a lot. Worrying aloud about trade and investment deficits is deeply unfashionable, sounding like a 1970s throwback. Over the coming year, that fashion could shift.

What of oil prices? Global markets are clearly flooded with crude, as Saudi Arabia pumps aggressively in a bid to break upstart US shale producers. With Brent below $37 a barrel, close to 11-year lows, lots of folk are predicting (and hoping) cheap oil is here to say. That would certainly benefit Western oil importers such as the US (and, increasingly, the UK).

Yet oil below $50 continues to contradict the long-term fundamentals of ever-rising global demand and the geological and logistic constraints on future increases in supply. The “Chinese demand is falling” story, for example, has been ridiculously over-hyped. Yes, the economy of the People’s Republic has slowed, and will probably expand by just 6pc this year, down from 7pc in 2015. Yet even the Energy Information Agency, a branch of the US government, points to a 2.8pc rise in Chinese oil consumption last year and another 2.7pc increase in 2016.

In the US, the “rig count” of oil production facilities in operation is down a huge 62pc year-on-year, while inventories show signs of peaking. The old adage – “low oil prices are reversed by low oil prices” – remains true, and not just in the US. Across the world, investment in oil exploration and production nosedived to $550bn last year, from $700bn in 2014, creating the future shortages that will cause prices to rise.

In the absence of a major financial meltdown, oil will certainly end 2016 north of $60 a barrel, in my view. We could even see a relatively quick return to $80, if Saudi succumbs to domestic financial pressures and the geo-politics of Opec shift.

We should, anyway, be careful what we wish for. Cheap oil boosts the West, while undermining the governments of energy-exporting nations we view as recalcitrant such as Venezuela and Russia. Yet low crude has lately caused alarming distress levels on junk bond markets, as heavily-indebted small- and medium-sized US energy producers have fought to survive. Western ratings agencies are finding it hard to suppress their concern. This is another unfashionable issue that could come to prominence over the next 12 months.

My final fear for 2016 is that world trade slows further, acting as an additional anchor on global growth. Last year, trade grew by just 2.4pc, the lowest figure for many years and down from 3.4pc in 2014. The Doha trade “round” has jus been officially abandoned, the first failure of a multi-lateral negotiation since the 1930s. The danger now is that protectionism rises, and diplomatic rancor grows. Clear-minded people across the world must hope that doesn’t come to pass.

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