Skip to the content

Three potential nightmare scenarios investors should beware of

01 November 2018

Barclays Smart Investor’s Will Hobbs highlights three potential events which are looming in investors’ minds and how likely they are to materialise.

By Maitane Sardon,

Reporter, FE Trustnet

A return of global debt problems, a break-up of the EU and a collapse of the Chinese economy are three nightmare scenarios that could challenge investors’ portfolios, according to Barclays Smart Investor’s Will Hobbs.

Head of investment strategy Hobbs said while it’s uncertain whether the end of the cycle has only just begun or whether a sustained downturn is looming, there are other headwinds investors need to be mindful of.

“Equity and bond markets have been increasingly volatile in recent weeks as investors have reacted to rising US interest rates, concerns about the escalating trade war between the US and China, and the ongoing Brexit rumblings,” said Hobbs.

“Much of the falls in equity markets – in particular – are so far down to little more than speculation, with company results remaining broadly robust across many sectors, but jitters are nonetheless turning into something more meaningful as losses start to accumulate.”

Below, he highlights the three potential nightmare events and considers how likely they are to materialise.

 

A return of global debt

Last month, the International Monetary Fund said global debt hit a new record high of $182trn, increasing by more than 50 per cent since the global financial crisis mainly as due to an increase in Chinese and US debt

Indeed, Hobbs said a return of global debt issues continues to be the favourite source of prospective economic apocalypse among certain “doom-mongers”.

“As measured by global gross debt as a percentage of GDP, the excesses of 2007 represent just a staging post to our current state of bloated excess,” he explained.

Net debt as a percentage of GDP

 
Source: IMF

“The nightmare is that most asset prices seem crazily reliant on central bank largesse, the ‘band aid’ which has allowed us to forget that the modern global economy is little more than a debt-based confidence trick.


“As those same central bankers try to remove their atrophied patients from the monetary drip – as we are seeing in the US right now – this trick could be cruelly exposed, causing equity markets in particular to plunge as part of a long-deferred mean-reversion trend,” Hobbs explained.

The reality, Hobbs noted, is that the personal perspective is near irrelevant to how investors should think about it at the global or even country level.

“What if the great financial crisis actually had less to do with aggregate levels of debt and solvency, but rather liquidity – a sudden vacuum of confidence in a system that has always been reliant on it – even before we cast our monetary system adrift from gold?” he asked. 

The strategist said investors should remember that debt is also wealth, as one person’s liability is another’s asset.

He explained: “Mortgage debt is an asset for banks; government bonds are held in your pension; debt issued by companies is financed by investors and banks.

“We, the consumers, own shares in many of these institutions and even have a claim on government given that it is funded by our taxes.

“This points to the fact that at the global level, there can be no net debt, at least not until we manage to find any willing extra-terrestrial suckers/creditors.”

Therefore, Hobbs said the gross amount of debt owed by the global economy is “meaningless in isolation” despite the horror it generally provokes.

Furthermore, he said according to its estimates, the ‘choke’ point for US interest rates for either the US economy or the wider world in aggregate still looks to be “some distance from current levels”.

 

Break-up of the EU

Another nightmare scenario, according to Hobbs, is the break-up of the EU as a result of the “still smouldering” eurozone crisis that struck markets five years ago.

“Most recently it is populist Italian politicians who are the likely agents of the break-up, but before that it was mooted to be the UK’s referendum vote, the Greeks and various other discontented members,” explained Hobbs. “If there was to be a break-up, it would likely be an economically savage event for the world economy.”

However, the strategist said although we should never rule out the break-up of the euro, investors shouldn’t underestimate the weight of history and “the lack of credible alternatives to further integration”.


“If the crisis of the last few years has taught us anything, it is that the major actors within the euro, from the German and French politicians to the European Central Bank, are more formidably committed to keeping the euro together than many might have previously imagined,” he said.

“Besides which, Italian households hold assets worth several times’ the value of the debt the Italian government owes, which represents a very strong reason not to devalue both by returning to the lira.”

 

A Chinese collapse

A final potential nightmare for investors, according to Hobbs, is the so-called ‘hard landing’ for the Chinese economy, which he said has long been “fetishised” by western commentators and some very vocal hedge fund managers.

“A soaring debt pile, a wobbly housing market and a western commentariat scarred by their collective failure to spot the troubles that lay in the US sub-prime sector are all contributing factors,” he explained.

China’s government gross debt as a percentage of GDP

 

Source: IMF

“How likely is it? For their part, Chinese policymakers have been introducing a range of regulatory reforms designed to reduce economy-wide leverage and curb financial stability risks.

“These have had the side effect of tightening liquidity and reducing credit availability, leading to the current slowdown in the economy.”

While Chinese equities make up the largest component of emerging markets equity indices and the Chinese economy is a key source of external demand for the wider Asia region, a more serious downturn could be detrimental to many investment portfolios, added the strategist.

So far, Hobbs said it believes policymakers have sufficient controls over key levers of the economy to prevent an over-tightening scenario, with recent actions paying testament to that.

The ongoing slowdown has therefore been gradual, and the risk of it metastasising into a more serious downturn remains low, Hobbs concluded.

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.