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Macroeconomic & Geopolitical

The Risks Ahead That No One Fully Understands

22 October 2021 - 2 min read

The economy may return to more “normal” patterns next year, but it will also bring hazards we have never seen before.

It’s the financial version of Newton’s Third Law: “Every action brings an equal and opposite reaction—and a lot of unintended consequences.” 

We’ve just lived through a huge amount of action. Currently, at least three “reactions” bear close watch amid an otherwise sunny outlook. Receding government support, shifting post-COVID preferences, and rapid financial innovation may not metastasize into the next crisis anytime soon, but they will likely create air pockets as the global economy gains more altitude.

The visible risks to the current recovery are well advertised and will hurt returns if they take root. Everyone knows inflation may last a little longer or demand may stagnate if the U.S. infrastructure plan fails. No one would be amazed. But investors need to watch for the dangers that are only barely discernible now, even if they will be obvious to all in hindsight.

Today, for example, it’s pretty easy to connect the historic emergence of China’s economy at the turn of this century to the near collapse of the European currency union a decade later. It’s hardly a straight line, but the links can be drawn. 

China’s integration into global trade flows brought booming export revenues, which fed a vast expansion in domestic savings, which fueled massive purchases of U.S. treasuries (and other government bonds), which drove global interest rates lower, which touched off an insatiable reach for yield, which fertilized fresh waves of financial engineering, which financed expansive lending to unqualified U.S. homebuyers, which exposed German and French banks to sudden losses, which led to an abrupt liquidity stop in weaker European economies, which revealed a badly overextended Greek budget, which exposed structural fault lines in a currency union that everyone took for granted.

“Everyone knows inflation may last a little longer or demand may stagnate if the U.S. infrastructure plan fails. No one would be amazed. But investors need to watch for the dangers that are only barely discernible now, even if they will be obvious to all in hindsight.”

The spectacular government response to the pandemic has launched a surge in economic activity on par with China’s emergence into global trade flows two decades ago. Even as rates may rise and support normalizes, markets are awash in liquidity. Corporate and household balance sheets look solid. The International Monetary Fund has penciled in 4.9% growth next year compared to 2.8% in 2019, which suggests a healthy outlook for risk markets.

But the surge in financial markets has also triggered notable bankruptcies in hedge funds and Chinese property. The problem beneath the financial excess, however, is that these abundant capital flows disrupt the competitive landscape in unexpected ways. Strong firms can suddenly face headwinds when weaker competition can tap into cheap capital. Investors can’t buy “the market” or even a sector without carefully differentiating among business models that look resilient amid these shifting currents.

Second, new patterns of spending are taking shape as COVID continues to cause havoc with unpredictable variants and in unvaccinated parts of the world. Lest we become too sanguine about next year, a fresh Harris Poll across 27 countries comprising 81% of the world’s GDP found 56% of respondents believe the worst of the pandemic still lies ahead. In a stunning disconnect from the conventional wisdom of markets, more than three-quarters of respondents believe a global recession is nigh.

That doesn’t sound right given the current strong earnings season, but the pandemic’s disruption continues to reshape expectations and demand patterns everywhere. Even if the overall trajectory continued to improve, individual firms will see unpredictable shifts in customer preferences, triggering pressure on margins and new supply-chain configurations. Changing behaviors among workers are already upending forecasts about the U.S. labor market.

Finally, the innovation that is transforming traditional finance bears closer scrutiny, too. Some of it is transparent and well-understood, but the combination of expanding capital flows and a lengthening list of new products carries risks. Fintech startups that challenge traditional banks and distributed ledgers that upend clearing and settlement offer promising new gains and, on their own, the uncertainty can be managed.

The real challenge for regulators and investors, however, lies in knowing how their interaction might create unexpected problems. What if systemic banks can’t earn a profit amid the new competition? Will alternative currencies disintermediate traditional financial markets? Will distributed ledgers really function in a market crisis?

Defense Secretary Donald Rumsfeld famously spoke about the “known knowns,” which in the current market context are the risks of inflation or stagnation that are hotly debated and partly priced in. The “unknown unknowns,” like a global pandemic, will always catch us off guard. But there are categories of “known unknowns” that we can already dimly see and will still deliver real shocks for those caught unaware. That’s where discerning investors will be keeping a sharp eye out.

Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

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