How stressed is the global economic system?

Stress is a much-used word nowadays.

But it’s still a very important issue.

If the global economy gets seriously stressed, events such as recessions or even depressions are likely to result.

And these impact all of us in one way or another. We either lose our jobs, our money in the stock market, or the equity in our houses. Or all three.

So, amid talk of potential recession, how can we measure financial stress? And should we fret about it now?

Don’t tricked by the VIX

You may well have heard about the VIX (the Chicago Board Options Exchange Volatility Index), Wall Street’s measure of implied volatility. In simpler terms, this indicates how likely is the US stock market to rise or fall from any given level.

But while the VIX and its counterparts in other markets are useful barometers, they’re only indicators that relate to financial markets. They don’t give us any idea about the overall economy – which might be telling us a very different story.

So we need something much broader. A full financial stress barometer can show us how financial asset prices and the real economy interact. If financial conditions tighten, economic expansion is likely to suffer. If they ease, growth gets a boost. Most economic downturns have been preceded by increased financial stress.

It’s still not so simple gauging the latter, though. For example, we’re always writing about central banks and their interest rate policies. Yet financial conditions can – and often do – move in the opposite direction to these.

So we need to add in other factors, though, such as corporate credit spreads (i.e. the difference between the interest rates that companies and governments pay to borrow), exchange rates and – yes, share prices as well.

Further, some of the elements that we’ll need to monitor can give mixed signals about the economic outlook.

Falling government bond yields – as we’ve seen in recent weeks – suggest easing financial conditions that could encourage future economic growth rates. But it’s not that simple. Bond yields are declining because markets are beginning to contemplate central bank policy easing. In other words, they’re dropping because fears over economic growth are increasing.

Clogged up and nowhere to go?

During the great financial crisis a decade ago, I was an editor at Moneyweek. And one of my favourite topics was the HSBC Financial Clog index.

Introduced at the start of 2007, the Clog index is a broad measure of the US financial system and provides a snapshot of the total stress level using four factors. These are interbank lending conditions (based on money market spreads), financial institution default risk (measured by credit default swap – CDS – spreads), mortgage credit spreads, and equity volatility, gauged by our friend the VIX.

Lots of financial jargon there. But in plain English, the Clog index largely compares rock solid financial benchmarks with more variable higher-risk measures. The more these diverge, the greater the stress in the system.

Very useful information, you’d reckon.

So what’s the Clog saying now? I’ve been googling it and can’t find any recent data.

I’ll keep trying. But no matter.

New horizons

Another stress indicator has just appeared on the radar screen.

In fact, four. Global researcher Capital Economics has just developed a new set of Financial Conditions Indices (FCIs) for the US, UK, Eurozone and Japan. And the firm has adjusted these FCIs for those misleading signals about future expansion, meaning that they should prove to be a fairly good real-time current indicator of advanced-economy GDP growth.

“Three key messages stand out”, says Capital Economics’ Neal Shearing. “First, FCIs across all four economies (and in particular the US and Europe) tend to move together.”

That said, the old adage about America sneezing and the rest of the world catching cold holds sway. US financial shocks remain the most powerful on the planet, though they’re much less correlated with Japan than elsewhere.

“Second, economic slowdowns tend to follow a sharp tightening of financial conditions, rather than when the FCIs pass a particular threshold. We should therefore put more emphasis on changes in our financial conditions indicators rather than their level”.

“Finally, our FCIs show that conditions tightened in the major advanced economies in the final months of last year before stabilising in recent weeks as equity markets have rallied and credit spreads have narrowed.”

And Shearing’s conclusion?

“We expect financial conditions to tighten further this year in major advanced economies reflecting, but also exacerbating, slower economic growth”.

Note that comment about ‘reflecting but also exacerbating’. Put another way, the global economy could be set for a self-perpetuating downward stress spiral. That’s not likely to be good news for global stock markets over the coming months.

I believe this is a warning that we shouldn’t ignore.

If you’re a Strategic Intelligence subscriber, of course, none of what I’ve written about today will be a huge surprise. Indeed, in this month’s printed edition, my colleague Jim Rickards has been examining the ‘Great Growth Hoax’ that he believes is becoming a serious future threat to your wealth.

Jim has been accused of being an obsessive gloom-monger. He isn’t, at all. But he is very much on your side against governments, major banks and big corporations who he believes can’t be trusted to safeguard private investors’ best interests.

In the years ahead, he’s just the sort of ally you’ll need.

To read more of Jim’s analysis in Strategic Intelligence and get access to all our latest research, click here.

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