The global economy is set to experience a “rocky recovery”, according to the IMF’s latest World Economic Outlook, with risks heavily skewed to the downside. Among the risks impacting the global economy are record international debt levels, strains appearing in certain bank and non-bank lenders after the sharp increase in interest rates over the past year, tighter credit conditions, heightened volatility, and de-dollarization initiatives.
According to S&P Global Ratings, global debt has hit a record $300 trillion – more than three times the global gross domestic product and an average of $27 500 of debt per person. Government debt-to-GDP levels have surpassed 100%, increasing to 102% in 2022 from 76% in 2007.
Canadian household debt-to-income ratios reached a peak 184.3% in the third quarter of last year before declining to 180.5% in the fourth quarter, which is still much higher than the 177% in the third quarter of 2021.
Rising house prices and lagging income growth in Canada have meant that house prices have outpaced income growth by more than 40% over the past decade. This is evident in Statista’s measure of the house price-to-income ratio rising to 143.5 in the third quarter of 2022 versus 100 in the 2012 base year.
According to The Measure of a Plan, the house price-to-income ratio in Canada was 8 times in January this year, ranging from 12.1 times in Victoria to 3.1 times in Moncton.
Similar trends of house prices rising more rapidly than incomes have been observed in other countries, such as the US and several European countries, including Czechia, with the highest ratio in the world, Netherlands, Portugal and Luxembourg. However, the house price-to-income ratio in the US is at a more reasonable 1-to-1 ratio versus Canada’s more worrying average 8-to-1 ratio.
Fortunately, home prices have started coming off and incomes have risen since 2000, which means that should these trends continue house affordability in Canada will improve.
S&P says it will take a “great reset” to alleviate historically high debt levels, involving more cautious lending, reduced overspending, restructuring low-performing enterprises, and writing down less-productive debt.
Authorities have become increasingly concerned with non-bank lending facilities, particularly the buy-now-pay-later schemes that allow consumers to buy goods and pay them off in installments. With more borrowers falling into arrears on these popular payment schemes, the UK Financial Conduct Authority (FCA) is set to be given the regulatory authority to clamp down on these non-bank lenders.
In an FCA-commissioned review, the interim chief executive warned that these schemes could harm consumers significantly. Thus clear protections need to be put in place to protect borrowers taking advantage of these affordable, non-bank credit products. Meanwhile, the regulator has already taken action by writing letters to the CEOs of 291 payment companies to say they will be shut down if they don’t address unacceptable risks to consumers.
There has also been a significant shift to non-bank financial entities in the US, which are important in providing leveraged corporate lending to commercial real estate companies, agricultural firms, and consumers.
Also known as the shadow banking system because it is not subject to the same regulations governing traditional banks, the concern is that any losses incurred during difficult market conditions could eventually be transferred to the banking sector.
The strains in the US banking system were so far successfully contained to a few regional banks. Swiss bank Credit Suisse was the only bank outside the US affected by the sharp deterioration in investor sentiment. There were concerns that other banks with significant exposure to long-term Treasuries on their balance sheets were at risk, too, but these haven’t materialized, yet. The decline in yields during April has further reduced their unrealized exposure to duration risk.
Regulators and large banks have stressed that the banking sector is in good shape because its highly regulated and they are well-capitalized. The banks that were affected were in the minority. Their balance sheets were compromised by a specific issue that was unusual because long-term bonds are expected to be safe-haven investments. The regional bank bought these assets assuming that inflation would be transitory, in the Federal Reserve’s own words, at the time they built up exposure to these assets.
However, Morgan Stanley does warn that the turmoil is likely to lead to tighter lending standards and financial conditions because regional banks with less than $250 billion in assets account for about half of the commercial and industrial loans, 70% of commercial real estate loans and 38% of residential mortgages.
Thus, the sector most at risk as a result of the bankruptcy of SVB and Signature Bank is expected to be the global commercial real estate (CRE) sector as regional banks tighten up their lending standards, making it more difficult for CRE companies to access the finance they need to grow. In its April Financial Stability Report, the IMF notes that banks with total assets less than $250 billion account for about three-quarters of CRE bank lending, “so a deterioration in asset quality would have significant repercussions for their profitability and bank lending appetite.”
However, in its assessment of the implications for the CRE, UBS’s Chief Investment Office concludes that CRE exposure at banks is currently manageable and unlikely to rise to the levels seen in the 2008 global financial crisis. It says: “Rising interest rates, a slowing economy, and increasing vacancy rates in office buildings have weighed on the sector in the last couple of years. Now, an expected credit crunch on the back of the rising cost of funding for banks may further compound its troubles. However, in our view, while the risks in CRE have certainly increased, it does not pose a wider systemic risk.”
Also, the troubled office sector is only a small segment of the entire CRE sector, limiting its impact on the outlook for the industry.
The most important lesson from the banking turmoil was how quickly bank customers withdrew their deposits at the regional banks because of their easy access to their funds online and the speed with which the news spread over social media and news sites online. Regulators will need to rethink their systems to adapt to the new world of 24/7 digital banking to avoid the risk of further banking turmoil or, at worst, a systemic banking crisis in the future.
De-dollarisation has moved up the news agenda, as tensions between the US, China, and Russia have mobilized the BRICS emerging market grouping, including Brazil, Russia, India, China, and South Africa, to move forward in creating a BRICS currency. Plans are likely to be presented at the BRICS Summit in South Africa in August. There is speculation that other countries, including Canada and Mexico, have also shown interest in settling trades in a BRICS currency rather than the dollar.
China’s CNOOC and France’s Total made the first yuan-settled LNG trade in early April through the Shanghai Petroleum and Natural Gas Exchange. The deal is a significant first because it is a trade that would usually have been settled in dollars, signalling an emerging appetite for shifting away from using the dollar as the international currency of choice in global trade.
Globally, the dollar’s role as a reserve currency is also waning. Recent analysis done by Eurizon SLJ Capital Ltd shows just how much the dollar share of official global reserves has declined. Dollars now comprise about 58% of global reserves versus some 73% in 2001. And the pace has been accelerating. The US currency has lost about 11% of its market share since 2016 and doubled that amount since 2008 when you adjust for exchange rate movements.
On the ESG front during April, Blackrock’s CEO Larry Fink also made waves at the world’s largest asset management company when he adjusted his stance on prioritizing ESG factors in the investment process in his annual letter. Notably, he did not refer explicitly to ESG this year but said that business cannot be the climate police and that it’s the role of government to “provide clear pathways and a consistent taxonomy for sustainability policy, regulation, and disclosure across markets.”
Despite the drama in the US over the debt ceiling, overall, we see policymakers doing what they must do to temporarily plug holes in the global economy and financial system to delay a necessary cleansing process, which would involve greater pain. Their action could lead to a worse situation down the road, but, clearly, they are hoping it will be long after they have handed over the reins. At some stage, however, the chickens will come home to roost. To safeguard our clients against this eventuality, we remain steadfast in our mission to invest in quality businesses at reasonable prices as we believe this is the soundest way to build wealth over time.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 25 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca