Eye-watering levels of debt, low wage growth and the spectre of Brexit overhanging markets are among some of the scariest challenges currently facing investors, according to M&G’s Anthony Doyle.
Doyle, fixed interest investment director at M&G, said while markets have been remarkably resilient during 2017, there are still many reasons for investors to feel a sense of nervousness at the potential threats lurking around the corner.
He explained: “Sure, the geopolitical environment has thrown up a few frightening days which saw markets sell-off, but on the whole volatility has been muted and most asset class have generated solid total returns.
“That said, any horror movie fan will tell you that the scariest part of a horror film happens when things are relatively calm.”
Below, Doyle highlights five charts that might unsettle the most unflappable of investors.
ECB quantitative easing has propped up government bond markets
Source: M&G
Doyle said while the strength of the European economy and eurozone labour market has been a surprise story of 2017, this had been fuelled by the European Central Bank (ECB) and its quantitative easing (QE) programme.
“Many point to the fall in yields on peripheral area debt as a sign that the euro sovereign debt crisis is well and truly over,” he said.
“The question is, do falling yields signify increasing confidence in the ability of euro area nations to repay their debt, or do they simply reflect the asset purchases that the ECB has conducted since the QE programme started?”
He said the above chart, published by the International Monetary Fund, shows official purchases of eurozone debt has eclipsed net issuance since May 2015.
He added: “Indeed, ECB QE is currently seven times bigger than net issuance. So, is it any wonder why yields have fallen, and what happens when the ECB tries to turn off the easy money tap?”
Debt is a beast that cannot be tamed
Source: M&G
Doyle said the debt-to-GDP ratio in the G20 group of advanced economies has grown steadily over the past decade to more than 260 per cent or $135trn.
“It’s a big number, and whilst it is true that this debt represents an asset on another balance sheet, it is undeniable that governments, corporates and households have never lived beyond their means by so much,” he said.
“It is for this reason that advanced economy interest rates are so low, and are unlikely to return back to levels observed before the 2008 financial crisis. For investors, that means you are going to have to take more risk to generate positive real returns.”
Investors have herded into risky assets
Source: M&G
Accommodative monetary policy has encouraged investors to invest in funds focused on riskier assets, the M&G fixed interest director said, and although central banks think this will help generate inflation it could also represent a significant risk to the global financial system.
“A significant issue for the performance of investments in riskier asset classes like high yield and emerging markets would be a spike in investor risk aversion or some form of external shock – like the oil price collapse in 2014,” he said.
“If investors head for the exits, this could trigger sales of riskier and less liquid assets held in open-ended mutual funds, resulting in substantial price declines.
“The very gradual pace of monetary policy normalisation may be exacerbating these risks, as continued low volatility and low yields encourages investors to further increase credit risk exposure, duration and financial leverage.”
Despite low unemployment rates, wages aren’t rising materially and productivity is poor
Source: M&G
Doyle said the low wage growth is a sign of labour’s declining pricing power as a factor of production and is a problem given that labour markets have traditionally been seen as key for inflation.
“For the first time, central bankers like [ECB president] Mario Draghi and [Bank of Japan governor] Haruhiko Kuroda have been calling on unions to increase wage demands, with Draghi stating wages are the ‘primary driver of inflation’,” he said.
“The more workers can strengthen their pricing power, the more likely it is that wage demands will be agreed to by businesses.”
However, the drop in union density and coverage combined with a fall in employment protection has left workers in a weaker position to press for higher wages.
He added: “Unless workers can start demanding higher rates of pay, it is likely they will continue to suffer real-wage declines.
“This has been the case in the UK, with unit labour costs and inflation growing by 16 per cent and 25 per cent respectively since 2008.”
Of course, there had to be a Brexit chart
Source: M&G
Finally, the fixed income specialist noted that reports suggest the ongoing Brexit negotiations have not progressed in line with expectations, posing difficulties for the UK’s future trading relationship with the bloc.
Indeed, the above chart shows the scale of the challenge, representing the share of total UK trade by trade agreement.
“In March 2019, unless some form of deal is agreed, the UK will have to negotiate trade deals with the majority of its current trading partners,” it said.
“This would be a major challenge as complex trade agreements are not easy to negotiate and often take years to agree to. If the UK finds itself outside the EU single market and the customs union, tariff and non-tariff trade barriers (like quotas, embargoes, and levies) are likely to be implemented between the UK and its main European trading partners.
“Some sectors and companies may face much more restricted access to the European market, and that will prove to be a significant headwind to UK economic growth in the short term.”