The risk of accidents

Growth downturns can expose vulnerabilities that increase market risks

There are two drivers of market downturns: Cuts to forward earnings estimates and a decline in the price-to-earnings (P/E) multiple that investors ascribe to them. A 15 per cent fall in earnings estimates and an 18 per cent lower P/E, for example, would mean a 30 per cent market correction. A reduction in P/E multiples usually drives the first part of a correction (as markets move ahead of changes to analysts’ forecasts), and cuts to forward earnings drive the subsequent declines.

Over the past year or so (the market peak varied from country to country), forward P/E multiples have corrected quite meaningfully, and are comparable to such declines seen around past US recessions. This reflects normalising policies (higher US interest rates mean a lower P/E ratio), and rising risks, both geopolitical and macroeconomic (higher risks mean lower P/E).

The debate now shifts to how much downward risk exists to earnings forecasts. It should be possible to estimate the downside risk within a reasonably narrow range by isolating sectors that saw above-normal earnings growth since 2019 and assuming that their earnings fall back to trend or to pre-Covid levels. Why then are the markets continuing to be so volatile?

Just as faster economic growth solves many problems, slower growth can unearth hidden ones. For example, slow growth and high interest rates could force a company with high levels of debt to default. This probably explains why market downturns end only when earnings forecasts have bottomed out, and not before that, as one would have expected given that markets are forward-looking.

The more obvious areas of risk do not appear to be flashing red currently, but these are early days, and one needs to be watchful. For example, junk bond prices in the US have fallen in the fear that zombie firms that survived for years on raising new loans to repay old ones would go bankrupt, though default rates, while the highest since 2020, are barely off the bottom. The leading indicator here is the sharp decline in new junk bond issuance, which leads a rise in default rates by a few quarters.

Emerging market (EMs) currencies have depreciated against the US dollar, but mostly less so than developed markets currencies (a few exceptions like Turkey whose problems predate the recent downturn). Remarkably, this is despite large portfolio outflows from EMs in the last nine months: Only during the 2008-09 global financial crisis (GFC) were outflows worse. Further, the rise in EM sovereign bond yields is lower than in the US, implying a lack of stress in local currency bond markets thus far. As capital accounts in many emerging markets are not fully open, the risk of significant outflows is limited to a handful of those that have high foreign ownership of local currency sovereign bonds.

Five months of elevated energy prices have also demonstrated, somewhat expectedly, that governments, whether in developed or in developing economies, will try to subsidise energy consumption. While this supports near-term growth, it does not address the shortage in energy, and the inevitable dent to global growth. On this count too, given comfortable current account balances and  foreign currency reserves in most EMs, risks appear low for now. However, this is likely to keep energy prices higher for longer, prolonging fiscal and balance of payment pressures, as the demand destruction that high energy prices would otherwise have caused does not occur.

Illustration: Binay Sinha

The situation appears less sanguine in some frontier markets, some of whom have seen a 6 to 10 per cent point rise in sovereign bond yields, and currencies for some have depreciated by 10 to 30 per cent against the US dollar. The risk of a contagion appears low for now though: Total sovereign debt for all frontier markets is less than 2 per cent of all debt, is mostly bilateral or multilateral (that is, not through bond portfolio investors), and their combined share of global gross domestic product is less than 3 per cent. So even a sharp decline in growth for these economies may not affect global growth meaningfully. Some countries currently in trouble, like Sri Lanka and Laos are small enough for economically larger neighbours to bail out given the geopolitical interests.

One major risk though is yet to play out. Unlike in other such recent episodes, where the primary change had been monetary (first low rates and then a sudden tightening), this time the spillover effects of excessively loose US fiscal policy showed up as well. The surge in goods exports buoyed EM economies during Covid: The increase between CY19 and CY21 was 4-15 per cent of GDP for Asian economies (2 per cent in India).

This is likely to reverse, as the extraordinarily strong goods demand in the US, pushed by a strong fiscal stimulus in the middle of the pandemic (when services consumption was impossible) falls back to trend. Excess finished goods inventories at US retailers and wholesalers mean more pressure on order flows. Demand elsewhere is weak too, not least in China, where persistent weakness was visible even before lockdowns pushed it lower. The downward lash of the supply-chain bullwhip is already visible in steep declines in metal prices and in upstream technology components like panels and memory chips.

The easing of Covid restrictions may provide some buffer to headline growth, but perhaps may not be enough to offset fully the growth headwinds from falling import orders and falling metal prices. Several of these economies also lack the policy space (both fiscal and monetary) to provide a local stimulus to support aggregate demand. Sovereign debt to GDP increased meaningfully in most countries in the last two years (by 10 to 21 per cent points from the pre-Covid levels), and their central banks have had to raise interest rates in tandem with the US Federal Reserve to keep their currencies stable.

These risks are meaningful for some developed market economies as well. For example, Credit Suisse economists estimate that Italy’s debt sustainability requires 10-year bond yields at less than 3 per cent. While yields have come down sharply from 4.25 per cent seen three weeks ago, they are still above that threshold. The recent fall in US government bond yields may help, but it reflects market concerns shifting to weak growth from high inflation — the fall in growth expectations may offset the fall in yields.

These uncertainties are an overhang on financial markets, which may remain volatile until they have quantified losses from the economic slowdown, and the risk of potential accidents has fallen.

The writer is co-head of APAC Strategy and India Strategist for Credit Suisse