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SYSTEMIC RISKS AND MACRO-FINANCIAL VULNERABILITIES WORTH MONITORING 

CIO Macro and Market Observations from Multi-Asset Solutions

August 30, 2022  |  5 Minute Read


Maria Vassalou, PhD

Co-Chief Investment Officer, Multi-Asset Solutions

Maria Vassalou, PhD

Amy Yifan Zhou, PhD

Multi-Asset Solutions

Amy Yifan Zhou, PhD


 

Given the backdrop of monetary tightening, slower growth, and geopolitical tensions, investors have started to assess whether the US and global economy is likely to plunge into a recession. While the probability and timing of a significant downturn are hard to estimate precisely, markers such as funding stress and credit risks can indicate a buildup of systemic risks. Additionally, developments in non-bank financial institutions have posed new challenges to financial stability, where regulation is still in early stages. Ultimately, not all adverse shocks will lead to system-wide failures but it’s prudent to identify market vulnerabilities and build downside protections preemptively.

 

Funding Risk

Financial institutions typically engage in liquidity and maturity transformation in different time horizons. During times of distress, funding costs can ramp up quickly due to surging demand for liquidity and higher counterparty risks. After the March 2020 turmoil, measures of funding costs have remained largely muted, yet this year’s macro shocks have led to periods of renewed stress. For example, the Forward Rate Agreement Minus Overnight Index (FRA-OIS) spread is a key indicator of funding risks. The spread may grow when the market demands higher risk premium, and in the wake of the Russia-Ukraine war, it widened to nearly 40 bps in early March and has remained somewhat elevated as recession fears continue to weigh on market outlooks (See Exhibit 1). While the current levels are not particularly alarming, funding market stress tends to accumulate rapidly with far-reaching ripple effects, and should be tracked closely in an environment where markets are susceptible to abrupt dislocations from economic surprises and geopolitical uncertainties.

 

Exhibit 1: Borrowing costs are rising but still below 2020 levels

 

Source: Bloomberg, Goldman Sachs Asset Management. As of 8/24/2022.

 

Credit Risk and Macroeconomic Spillover

Credit risk from corporates and sovereigns is another key aspect to monitor. Corporate spreads widened throughout the first half of the year, before falling back slightly during the summer rally; sovereign credit default swap (CDS) spreads have also come under more pressure on the back of a fragile outlook and country-specific event risks such as Italy’s political instability (See Exhibits 2 and 3). Currently, outlooks for global growth and corporate earnings have begun to weaken, with prospects particularly challenging for European economies that rely more on energy imports. A weaker euro is making energy costs more expensive for consumers and corporations, and plans for energy rationing could further dampen economic activities. Additionally, stagnant growth can in turn weigh on the strength of the euro and make prices even more prohibitively high. To help restore price stability and prevent inflation from becoming further entrenched, global central banks are expected to maintain the pace of monetary tightening. Therefore, credit conditions are expected to tighten, making defaults more likely.

 

Exhibit 2: Credit conditions are getting tighter in Europe…

 

Source: FRED, Goldman Sachs Asset Management. As of 8/24/2022.

 

Exhibit 3: … and Italian Sovereign CDS levels are rising

 

Source: Bloomberg, Goldman Sachs Asset Management. As of 8/24/2022.

 

Stress in corporate credit can be spread through its linkages to the sovereign and banking sectors. Higher corporate insolvencies and non-performing loans can lead to deterioration of banks’ asset quality and lower tax revenue for individual states; in turn, fiscal support and corporate lending can become more restrictive when the sovereign and banking sectors are stressed. Furthermore, sovereign and banking risks are mutually reinforcing – higher sovereign spreads reduce the value of domestic government bonds on banks’ balance sheet, whereas bank instability also implies higher sovereign risk. The so-called “sovereign-bank nexus” led to prolonged periods of distress during the  European Debt Crisis1 during the 2010s and has also been observed in emerging market economies. Over the past two years, countries have taken on large public debt for COVID-19 relief and much of the financing needs were absorbed by their own banks, leading to closer linkages between the sovereign and banking sectors as well as higher risks of a negative feedback cycle.

 

Systemic Risk Beyond Banks

Following the 2008 global financial crisis, US and global regulators have set up comprehensive efforts for systemic risk identification and oversight. Much of the focus has been on the banking sector, which was the principal source of systemic risk propagation at the time. However, in recent years, non-bank financial institutions have grown rapidly as an alternative source of funding and financial intermediation. While there are advantages of having diversified market participants, new challenges have emerged.

 

For example, in the US mortgage market, non-bank lenders are currently taking up about two-thirds of origination volume, and seven out of the top-ten lenders are now non-depository institutions. During the early days of the pandemic, the industry enjoyed a brief period of low interest rates and government stimulus packages, leading to a surge in refinancing activities and therefore higher profitability for mortgage companies. However, with rising interest rates and a slowing housing market, mortgage companies are now appearing to be increasingly vulnerable. Compared to banks, mortgage companies do not have funding access through deposits, have less diversified holdings, often take on riskier loans, and are more exposed to market shocks. Many of the large mortgage firms are also involved as loan servicers. When borrowers fail to make payments, the mortgage servicer may turn to short-term credit lines or potentially be forced to sell off its own assets in order to meet liquidity needs. Conversely, distress in the mortgage companies can reduce the total amount of credit available to consumers and suppresses economic activities further.

 

Investment Implications

To protect portfolios from downside risks, it is prudent to go beyond monitoring day-to-day fluctuations and further identify systemic risk concerns that may propagate and amplify financial distress. Currently, funding and credit risks appear moderate compared to earlier periods in the year, but they should be monitored as the global economy navigates through potentially challenging periods ahead. Structural issues in non-bank financial institutions are important from a financial stability perspective, which call for regulatory enhancements but are unlikely to slow down the pace of monetary policy tightening. Fallouts in the sector can also pose meaningful disruptions to the performance of risky assets. In light of these considerations, investors should be cautious about exposures that are more susceptible to liquidity shocks or exhibit unfavorable convexity in payoffs until we see a meaningful retracement of macro uncertainty and downside risks.

 

 

 

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See, for example, The Economist (2011), “Staggering to the Rescue: Europe’s Troubled Banks and Broke Governments are in a Dangerous Embrace.”

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