The Drumbeat of Systemic Risk
Stephen Roach (New York)
7-8-02
Notwithstanding the angst of June, financial markets have attempted to remain discriminating in assessing risk. Problems have largely been isolated before they have contaminated entire asset classes. That works fine as long as economic recovery stays on track. But as a double dipper, I fear that such discriminatory risk could well morph into systemic risk -- a wider and more lethal strain of financial market contagion that is reflective of the inherent flaws in markets and economies that exist under normal operating conditions. There are mounting signs that such a transition could well be close at hand.
Over the past several years, "bifurcation" has become a hallmark in the lexicon of market analysis. On the way up it was "new economy" versus "old economy." Then it became Nasdaq versus the broader equity market. On the way down, the dot-com implosion led the way, initially leaving the rest of the market largely unscathed. That was followed by similar downturns in information technology and, more recently, telecom. At each of these episodic milestones, however, the wider and more lethal strain of contagion associated with systemic risk largely absent.
There are signs that this is now beginning to change. Courtesy of the WorldCom debacle -- the most disruptive credit event since late 1998 -- credit spreads have widened back toward levels last seen in the aftermath of the September 11 terrorist attacks. For US investment-grade borrowers, spreads have increased by more than 30 bp since early June. While Steve Zamsky, our US corporate bond strategist, continues to stress that capital market access for good companies remains very much intact, he does concede that an increasing number of innocent victims have been affected. Steve Galbraith sees a similar tendency in US equity markets, noting that Aa and Aaa borrowers have significantly underperformed the broader market recently. Risk aversion is obviously spreading to the highest end of the quality spectrum -- a clear sign, in my view, that investors are beginning to anticipate a transition from discriminatory to systemic risk.
A similar -- albeit less dramatic -- pattern is evident in European capital markets. While Vivendi is not WorldCom, Neil McLeish, our European corporate bond strategist, argues that its troubles are symbolic of the mounting perils of firms with inappropriate capital structures. The widening of European investment-grade credit spreads to 120 bp in early July -- comparable to levels reached last September -- suggests that these concerns are also starting to take on a life of their own. Unlike the US, however, Europe has much more of a bank-centric credit intermediation process. As a result, the credit cycle is more a function of the health of the banking system than of risk in the corporate bond market. And on that count, it’s still comforting to note that European bank swap spreads have barely budged. Moreover, with European equity markets outperforming US equity markets by over 800 bp in the first half of 2002 (in dollar terms), the discriminatory tendency toward risk bifurcation seems more sustainable in Europe than in the United States.
I take the recent weakening of the dollar as yet another warning sign of the perils of systemic risk. America’s excessive dependence on the rest of the world to fund its external deficit was always a delicate balancing act. But in the aftermath of a serious corporate governance shock, together with the growing realization that a return to an era of single-digit returns on dollar-denominated assets could well be hand, capital inflows are suddenly much tougher to come by. While the capital flow data lag, the figures for the first four months of this year underscore a stunning slowdown of foreign demand for US securities -- portfolio inflows were off about 35% from the comparable period a year earlier. As Joe Quinlan notes, this downshift mainly reflects the diminished appetite of European investors; in the first four months of 2002, portfolio inflows from Euroland amounted to just $7.5 billion, fully 70% short of the pace a year earlier. In my view, external imbalances are a classic set-up for systemic risk. America’s outsized external imbalance highlights those risks all the more. The recent weakening of the dollar, in conjunction with the sharp recent reduction in foreign demand for US securities, suggests that the currency dimension of systemic risk may now be coming into play.
The same can be said of the policy stance of the world’s major central banks. Recently, both our US and European economics teams pushed out their long-held views of summer tightenings by the Fed and the ECB. The logic in both cases was the same: Financial-market distress, in conjunction with still fragile economic recoveries, suggests that any rate hikes should come later rather than sooner. Exceedingly low inflation makes the decision all the easier. The last thing central banks want is to lean the wrong way in shaky financial market conditions. As our economics team pushes out the likelihood of a "normalization" of short-term interest rates, we are, in effect, giving greater credence to the possibility that the financial markets are now reacting to an escalation of systemic risk.
All this underscores the important feedback loop between the financial markets and the real economy. An intensification of systemic risk is an unmistakable recipe for a higher cost of capital. Such an outcome would undoubtedly crimp the credit-sensitive sectors of the economy -- especially business capital spending but also homebuilding activity and consumer spending on durable goods. On that basis, alone, the mounting perils of systemic risk have the clear potential to trigger a double dip in a still fragile economic-recovery climate. Yet I worry especially about the repercussions of America’s corporate governance shock. To the extent that there is an accelerated cleansing of business accounting distortions, cost cutting can only intensify as US businesses seek to repair the resulting earnings damage. If the next wave of cost cutting entails headcount reductions -- precisely my fear -- then the resilience of the American consumer could finally crumble. And the double dip would then likely be on with a vengeance.
As the old saying goes, "It’s only when the tide goes out that you can see the rocks that lurk beneath the surface." History teaches us that systemic risk is, first and foremost, about the excesses of debt -- and the unintended consequences of debt-related perils in a weakened economic climate. Booms mask those perils, whereas recessions unmask them. And so now -- at low tide -- the excesses of the US debt cycle look all the more worrisome in that regard. Debt-to-GDP ratios are at record highs for American consumers and companies alike. America’s international indebtedness is also at an all-time record. Debt-related distress for an overly levered US economy can only intensify in a still fragile recovery -- to say nothing of a double dip. With credit spreads widening, battered equities still tender, the dollar under pressure, and the Fed likely to hold its fire, the drumbeat of systemic risk is getting louder by the day.
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