Nouriel Roubini's Global EconoMonitor

De-Risking Revisited

Until the recent bout of financial-market turbulence, a variety of risky assets (including equities, government bonds, and commodities) had been rallying since last summer. But, while risk aversion and volatility were falling and asset prices were rising, economic growth remained sluggish throughout the world. Now the global economy’s chickens may be coming home to roost.

Japan, struggling against two decades of stagnation and deflation, had to resort to Abenomics to avoid a quintuple-dip recession. In the United Kingdom, the debate since last summer has focused on the prospect of a triple-dip recession. Most of the eurozone remains mired in a severe recession – now spreading from the periphery to parts of the core. Even in the United States, economic performance has remained mediocre, with growth hovering around 1.5% for the last few quarters.

And now the darlings of the world economy, emerging markets, have proved unable to reverse their own slowdowns. According to the IMF, China’s annual GDP growth has slowed to 8%, from 10% in 2010; over the same period, India’s growth rate slowed from 11.2% to 5.7%. Russia, Brazil, and South Africa are growing at around 3%, and other emerging markets are slowing as well.

This gap between Wall Street and Main Street (rising asset prices, despite worse-than-expected economic performance) can be explained by three factors. First, the tail risks (low-probability, high-impact events) in the global economy – a eurozone breakup, the US going over its fiscal cliff, a hard economic landing for China, a war between Israel and Iran over nuclear proliferation – are lower now than they were a year ago.

Second, while growth has been disappointing in both developed and emerging markets, financial markets remain hopeful that better economic data will emerge in the second half of 2013 and 2014, especially in the US and Japan, with the UK and the eurozone bottoming out and most emerging markets returning to form. Optimists repeat the refrain that “this year is different”: after a prolonged period of painful deleveraging, the global economy supposedly is on the cusp of stronger growth.

Third, in response to slower growth and lower inflation (owing partly to lower commodity prices), the world’s major central banks pursued another round of unconventional monetary easing: lower policy rates, forward guidance, quantitative easing (QE), and credit easing. Likewise, many emerging-market central banks reacted to slower growth and lower inflation by cutting policy rates as well.

This massive wave of liquidity searching for yield fueled temporary asset-price reflation around the world. But there were two risks to liquidity-driven asset reflation. First, if growth did not recover and surprise on the upside (in which case high asset prices would be justified), eventually slow growth would dominate the levitational effects of liquidity and force asset prices lower, in line with weaker economic fundamentals. Second, it was possible that some central banks – namely the Fed – could pull the plug (or hose) by exiting from QE and zero policy rates.

This brings us to the recent financial-market turbulence. It was already evident in the first and second quarters of this year that growth in China and other emerging markets was slowing. This explains the underperformance of commodities and emerging-market equities even before the recent turmoil. But the Fed’s recent signals of an early exit from QE – together with stronger evidence of China’s slowdown and Chinese, Japanese, and European central bankers’ failure to provide the additional monetary easing that investors expected – dealt emerging markets an additional blow.

These countries have found themselves on the receiving end not only of a correction in commodity prices and equities, but also of a brutal re-pricing of currencies and both local- and foreign-currency fixed-income assets. Brazil and other countries that complained about “hot money” inflows and “currency wars,” have now suddenly gotten what they wished for: a likely early end of the Fed’s QE. The consequences – sharp capital-flow reversals that are now hitting all risky emerging-market assets – have not been pretty.

Whether the correction in risky assets is temporary or the start of a bear market will depend on several factors. One is whether the Fed will truly exit from QE as quickly as it signaled. There is a strong likelihood that weaker US growth and lower inflation will force it to slow the pace of its withdrawal of liquidity support.

Another variable is how much easier monetary policies in other developed countries will become. The Bank of Japan, the European Central Bank, the Bank of England, and the Swiss National Bank are already easing policy as their economies’ growth lags that of the US. How much further they go may well be influenced in part by domestic conditions and in part by the extent to which weaker growth in China exacerbates downside risks in Asian economies, commodity exporters, and the US and the eurozone. A further slowdown in China and other emerging economies is another risk to financial markets.

Then there is the question of how emerging-market policymakers respond to the turbulence: Will they raise rates to stem inflationary depreciation and capital outflows, or will they cut rates to boost flagging GDP growth, thus increasing the risk of inflation and of a sudden capital-flow reversal?

Two final factors include how soon the eurozone economy bottoms out (there have been some recent signs of stabilization, but the monetary union’s chronic problems remain unresolved), and whether Middle East tensions and the threat of nuclear proliferation in the region – and responses to that threat by the US and Israel – escalate or are successfully contained.

A new period of uncertainty and volatility has begun, and it seems likely to lead to choppy economies and choppy markets. Indeed, a broader de-risking cycle for financial markets could be at hand.

 This piece is cross-posted from Project Syndicate with permission.

7 Responses to “De-Risking Revisited”

jack strawJune 28th, 2013 at 4:22 pm

i disagree completely vis a vis your "war" view. the United States is at war currently and has been for 12 years. every area of the world is of interest to the United States as a consequence. this obviously makes the correctness of you call on gold all the more surprising since more often than not these "imperial designs" are bad for the economy. obviously the current one is bad for growth. we're looking at 1 percent here in the USA for probably a decade. and amazingly "that makes the USA the winner." the rest of the world has drawn the wrong (same?) lessons from 2008…namely "to take it to the dollar we must overproduce commodities and under consume at home." in short there is not build out of the financial/media complex as exists in the USA and exists no where else on the planet right now save for London. add to that an electrical grid on a continental scale "which rock bottom rates" (that will stay there for some time) and i think you get the picture. comparative advantage works in the USA even with growth rates of 1%. the question therefore becomes "what will Government do with all the money." the first thing appears to be "to replace Chairman Bernanke." Don't get me wrong this guy is probably the greatest Fed Chairman in history…but his political viability is now zero. i think Wall Street really got lucky with that guy…but hey, Wall Street also knew how to respond to his "liquidity." but now it's the Government's turn. "you gotta pay the Governor's quarter" and obviously the prime beneficiary of QE has been the Government! they will push Forward now.

StefanoJune 28th, 2013 at 4:37 pm

The main reason why this great recession is not going to end soon is that no prompt action was taken from the very beginning, as some, Nouriel being the head of the group, suggested to do.
Now we are caught right in the middle of it and there are basically no means to put the things back on the right track, but something can still be done to avoid the worst scenario, say social turbulence and, eventually, war.
So, personally, I bet most of the efforts should be put in this direction, rather than in trying to revitalize an anemic economy by temporary artificial drugs.

SchofieldJune 28th, 2013 at 5:54 pm

Big cheesey grin on Keynes face somewhere as he observes the failure of the attempts to carry on blowing bubbles by the Banksters in central banks around the world come to nought!

BWildsJune 30th, 2013 at 11:44 am

Not so long ago Moody's Investors Service lowered ratings on Italy, Portugal, Slovakia, Slovenia and Malta by one notch and slashed Spain's sovereign rating by two notches. The ratings agency also cut the outlook on France, the United Kingdom and Austria. The moves reflect the susceptibility of the countries to the growing financial and macroeconomic risks emanating from the euro-area crisis and how these risks exacerbate the affected countries' own specific challenges. We must wonder how soon America will trigger a down-grade considering the recently proposes budget. The 1.5 trillion dollar deficit America has ran each of the last several years means spending on every man woman and child in America, over 4,500 dollars more then the government takes in. Central Banks can only do so much, for more on this subject view my post below,

Rod GroleauJuly 3rd, 2013 at 1:06 pm

Knowone seems to recognize as “The Roaring 2000’s”,;, almost 20 years ago, that we have lost our biggest group of consumers (middle career middle class) as the baby boom bulge retires worldwide and the population of the industrial countries is imploding.

As it points out. We are in I uncharted economic waters.

Good sailing!

KathrynJuly 5th, 2013 at 6:38 pm

As we can see, the QE issued by the U.S., Europe, and China only did so much, and liquidity did not reach main street very well. Too much liquidity served risky bets by banks and hedge funds.

China now has shibor rates spiking, just like the U.S. and Europe did before their market crash in 2008. Chinese banks no longer trust what is on each others balance sheets (overleveraged mortgage loans that are defaulting).

Although many economists say we avoided "beggar thy neighbor" this time, we really did not as currency wars were another form of it.

How can Europe possibly avoid a serious blow up and default, unless Germany keeps paying the bond bills of all the PIIGS countries? Unlikely. It will be nearly impossible for them to resist the instinct to survive and cut the periphery loose, sorry to say.

China will probable make some major policy errors too, why else would they build build build when it was clear long ago that there were no buyers who could afford the buildings? They dont know what to do, thats why.