Global Financial Stability Fabio Natalucci Deputy Director - PowerPoint PPT Presentation

International Monetary Fund July 18, 2018 Global Financial Stability Fabio Natalucci Deputy Director Monetary and Capital Markets Department

Financial Markets Have Recovered from 2018 Losses Markets sold off in 2018, but have generally recouped their losses so far this year Returns by Asset Class (Percent) 30 2019 YTD 25 20 15 10 5 0 -5 -10 -15 -20 2018Q3 - Q4 -25 US corp IG Oil (Brent) China equities Commodities S&P 500 Eurostoxx 50 EM equities Topix US corp HY EM sov $ EM corp $ Gold Euro corp HY EM govts local Euro corp IG JGBs US T-Bills 1

Risk Assets Have Reflected the Ebb and Flow of Trade Tensions Trade tensions weighed on equity and credit markets Relative Equity Performance of Trade-sensitive Firms EM sovereign and Global High Yield Corporate Spreads (Relative to benchmark, index to March 2018) (Basis points) 120 1 2 3 4 5 6 EMBIG Global high-yield corporate 600 115 110 550 105 500 100 450 95 90 400 85 350 Euro area auto firms 80 US firms with high China sales 75 300 China firms with high US sales 70 250 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Note: 1. US initiated national security investigation into autos; 2. US announced 25% tariff on $50 bn Chinese goods; 3. US implemented 10% tariff on $200 bn of Chinese goods; 4. US tariff on $200 bn of Chinese goods hiked to 25%; 5. June FOMC meeting when policy rate expectations were revised lower; 6. G20 meeting. 2

EM Capital Flows Have Been Volatile Growth and trade concerns have weighed on EM portfolio Bond flows to China have been strong flows in recent months after index inclusion EM Portfolio Flows by Investor Type Index-Inclusion Related Flows to China (USD billions; three-month rolling sum) (RMB billions) 150 120 MSCI Total flows 100 announcement 120 Institutional 80 flows 90 60 40 60 20 30 0 0 -20 First phase of -40 First phase of -30 Global Agg Inclusion Retail MSCI inclusion -60 flows -60 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Taper Renminbi U.S. EM Change in foreign holdings of Policy Bank Bonds -90 tantrum devaluation election Sell-off Change in foreign holdings of Treasury Bonds -120 Stock Connect Northbound equity purchases 2013 2014 2015 2016 2017 2018 2019 3

Market Conditions for Frontier Issuers Remain Favorable Issuance is expected to reach new highs in 2019… … on favorable market conditions Frontier Market Sovereign Issuance: Volume Frontier Market Sovereign Issuance: Price (USD billions) (Percent; Basis points) Interquartile range (right scale) BB B+ B B- CCC 45 10 600 Median yield (left scale) 40 500 9 35 30 400 8 25 300 20 7 15 200 10 6 5 100 0 5 0 2010 11 12 13 14 15 16 17 18 19YTD 19E 2014 2015 2016 2017 2018 2019 4

Financial Conditions Have Eased … as market interest rates have fallen Financial conditions have eased in the US and euro area … Financial Conditions Indices United States: Contributions to Financial Conditions (Standard deviations from mean) (Standard deviations from mean) 1.0 0.6 Interest rates April Other Tightening House prices 0.8 2019 emerging 0.4 Corporate valuations WEO 0.6 market United States 0.2 economies 0.4 Euro China 0.0 area 0.2 -0.2 0.0 -0.2 -0.4 -0.4 -0.6 -0.6 -0.8 United -0.8 States -1.0 -1.0 2016 2017 2018 2019 2016 2017 2018 2019 5

The Inflation Outlook Have Deteriorated Market expectations of inflation have declined… … along odds of high inflation. Market Expectations of Inflation Market Implied Probability of High Inflation (Percent) (Probability of CPI > 3% for 1 year in 5 years, percent) 2.5 25 United States Euro area 2.0 20 1.5 15 1.0 10 5-year 5-year-5-year forward 0.5 5 breakeven inflation swaps US US Euro area Euro area 0.0 0 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 6

Investors Expect Monetary Policy Easing Further monetary policy easing is priced- in for AEs… … as well as many EMs Emerging Market Policy Rates Advanced Economy Policy Rates (Percent) Expected 1-year change in policy rate (bps) 2.5 80 IDN PER 60 2.0 ROM 40 MYS United States 1.5 20 RUS POL 0 1.0 THA United Kingdom ZAF -20 COL CHL IND 0.5 HUN -40 PHL BRA -60 0.0 Japan -80 MEX -0.5 -100 Euro area 0 2 4 6 8 10 -1.0 Current policy rate (percent) 15 16 17 18 19 20 21 22 20 7

Global Bond Yields Have Declined Further Global yields have fallen on expectations of policy easing … … leading to a rise in negative -yielding bonds Government Bond Yield Curves Global Bonds with Negative Yields ($tn) (%) United States Japan Market capitalization Germany Yield Yield 14 30 (percent) Share of total global bond market (rhs) (percent) October 2018 GFSR 3.5 3.5 April 2019 GFSR 12 3.0 3.0 25 Latest 2.5 2.5 10 20 2.0 2.0 8 1.5 1.5 15 1.0 1.0 6 0.5 0.5 10 0.0 0.0 4 -0.5 -0.5 5 2 -1.0 -1.0 0 2 4 6 8 10 0 2 4 6 8 10 0 2 4 6 8 10 Maturity (years) 0 0 Maturity (years) Maturity (years) 2015 2016 2017 2018 2019 8

Inversion of the Yield Curve Points to Downside Risks to Growth The tail of the distribution moves to the left when the Downside risk is higher ahead of recessions yield curve is included US Forecast Distribution: US Downside Risks to GDP Growth Conditional 1-year Ahead Real GDP Growth (Percent) (Percent) Including the slope of the yield curve 6 0.3 No financial conditions 4 2 0.2 0 5th percentile -2 0.1 -4 -6 0.0 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 1980 1985 1990 1995 2000 2005 2010 2015 Note: The slope is measured as the difference between 3-month and 10-year Treasury yields. This slope is used in the estimation instead of the financial conditions index. 9

Investors Expect Risks to be Contained in the Short-term …and market volatility remains compressed Equity investors believe downside risks are contained… US Equity and Bond Volatility US Equity Skew Index (Standard deviations from historical average) (Standard deviations from historical average) 3 5 VIX MOVE 2 4 1 3 0 2 -1 1 -2 0 -3 -1 -4 -5 -2 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 10

Easy Conditions Are Encouraging Corporate Financial Risk Taking … and leverage continues to rise Debt- funded payouts by US firms have risen further … S&P500 Nonfinanical Firms: Debt-Funded Payouts US Leveraged Loan Market (Percent of assets; annualized) (USD billions; Debt/EBITDA in multiples) M&A volume High leverage firm 300 7.0 Low leverage firm LBO volume High leverage firm (% of debt, rhs) Average LBO Debt/EBITDA (rhs) 250 6.5 1.5 3.5 3.0 200 6.0 1.2 2.5 150 5.5 0.9 2.0 1.5 100 5.0 0.6 1.0 0.3 50 4.5 0.5 0.0 0.0 0 4.0 2005 2007 2009 2011 2013 2015 2017 2019 2003 2005 2007 2009 2011 2013 2015 2017 2019 Note: annualized 2019 number based on data till May. 11

An “Unusual” US Monetary Policy Cycle Financial conditions have eased during the most recent monetary tightening cycle in the US US Financial Conditions Index (FCI) US Financial Conditions Index (FCI) During Tightening Cycles During Easing Cycles Financial conditions index Financial conditions index 5.7 2.0 2.0 1983 1986 1984 1987 1988 1994 1989 1995 1.5 1.5 1999 2004 2001 2007 1.0 1.0 2015 0.5 0.5 0.0 0.0 -0.5 -0.5 2019 -1.0 -1.0 0 100 200 300 400 500 0 200 400 600 800 Cumulative rate hikes (bps) Cumulative rate cuts (bps) Note: Based on GFSR FCI from 1995. Pre-1995 FCI is spliced using the Chicago adjusted FCI. 12

Unconventional Monetary Policies in the Next Recession? How much policy space is available? Central Bank Balance Sheet (Percent of GDP) 120 2008 2019 100 80 60 40 20 0 BOJ PBOC ECB BOE Riskbank Fed 13

Where Are We Headed…? S&P Index Returns through Tightening Cycles 150 140 Cycle starts 6 months afterwards 130 120 110 100 Cycle ends 90 80 1983 1986 1988 1994 1999 2004 2015 Treasury 10-year Yields through Tightening Cycles 16 14 12 10 8 6 4 2 0 1983 1986 1988 1994 1999 2004 2015 14