The Sum Of All Fears: What Happens If All The Tail Risks Are Realized?

Predictably, trade risk is front and center again for markets after Thursday’s news that Donald Trump has made time in his schedule for another farcical meeting with North Korea’s Kim, but not for Xi Jinping ahead of the March deadline beyond which tariffs on $200 billion in Chinese goods are set to more than double to 25%.

Meanwhile, threats to global growth (not the least of which are the trade tensions) continue to proliferate and Thursday’s EC forecast cuts underscore the notion that Italy’s slump may not soon abate (reassurances from PM Conte and FinMin Tria notwithstanding) and that the outlook for Germany has darkened considerably.

Equities are faltering and the dollar is on track for a seventh day of gains, the longest winning streak in more than a year, as financial conditions look set to tighten anew just a week on from the Fed’s dovish relent.

Also on Thursday, the BoE expressed growing consternation at the prospect of a disorderly of Brexit. “The economy is not ready for a no deal, no transition Brexit”, Carney said, adding that the “fog” from the ongoing soap opera “is creating tension.” A no deal Brexit, he cautioned, “could mean a substantial economic contraction.”

All of this lends credence to the notion that nothing was truly “resolved” in January and that central banks once again find themselves in a position of having to ride to the rescue with a coordinated dovish lean.

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It’s against this backdrop that Deutsche Bank is out with a sweeping special report that “focuses on what the world might look like in the years ahead” if “any one or more of the three biggest risks to markets (i.e., the escalating trade conflict, Brexit, and a China slowdown) “should take a realized turn for the worse.”

The bank assigns a 5-10% probability to the three “tail” scenarios which are, in brief (and this is a truncated version excerpted from the note):

1. A significant escalation of the current trade conflict with China and an extension to Europe. Higher tariffs (25%) are imposed on all US imports from China, as well as on imports of autos from Europe; China and Europe both retaliate in kind.
2. The UK leaves the EU at the end of March without a deal or transitional arrangements, with substantial ramifications for growth. We estimate the UK would lose about 4% of output relative to baseline over 2019-2020 and the euro area about 1%.
3. Our tail risk in China sees the leverage built up in China in recent years as an accident waiting to happen. A crisis could be touched off, for example, by a large shock to food prices that drives up CPI inflation and forces the PBoC to raise interest rates.

In the first scenario, Deutsche warns that a severe trade shock touched off by an escalation may well push the US economy into a recession, albeit a “mild” one. On the hard Brexit tail risk, the bank frets that the knock-on effects for a teetering Italy could be severe. If there’s a crisis there, Deutsche says it might well prompt them to “cut another 1.3% off euro-area GDP for 2019-2021. The China bit is interesting. Most commentators continue to worry about lower CPI/PPI and a broad-based deceleration, prompting rate cuts and further easing. But Deutsche notes that an inflationary shock and subsequent policy response could prompt “disruptive deleveraging” with serious ramifications for GDP.

Drilling down into the tail risks, Deutsche details the US recession scenario as follows:

We assume [a break down of trade talks and tit-for-tat tariffs] would hit the US stock market (indeed markets globally) hard, causing the S&P 500 to drop another 10% or so below the lows reached in recent months—well into recession territory. The resulting hit to consumer and business confidence and household wealth reduces US consumer and business spending enough to cause real GDP to fall by a total of 1.3% over three quarters beginning in Q3 this year and ending by Q2 next year. The financial market shock would be even more important than disruption to trade in driving this economic downturn.

Do note how the self-fulfilling nature of the transmission channel from financial markets to the real economy would likely be more damaging than the mechanical impact of the trade disruption under DB’s scenario. This speaks to the pernicious feedback loop between wealth effects, confidence and economic outcomes in an economy that depends on the consumer.

Moving quickly to the no deal Brexit scenario, Deutsche writes the following (and again, these are truncated excerpts from a much longer scenario analysis and should be read as such):

Under a no-deal, crash-out scenario we calculate UK GDP growth will be around 4% cumulatively lower than under our baseline scenario by end-2020. The UK will enter a two-year recession, with GDP contracting by 0.3% and 0.6% in 2019 and 2020, respectively, predominantly through a real income shock to private consumption, a drop in investment spending, and a collapse in trade volumes. The impact of no-deal Brexit on the euro area will be material. After the recent deterioration in economic conditions in the euro area, we are more concerned that the confidence and financial conditions transmission channels could be more costly than previously thought. We now estimate the net cost to euro area GDP at 0.8% of GDP in Year 1 and 0.2% in Year 2. Given our reduced baseline, a no deal Brexit would put the euro area economy into recession.

In other words, in addition to the catastrophic effect a no deal would have on the UK, that outcome would make an already tenuous situation in Europe worse. As alluded to above, the risk to Italy is considerable. Those forecasts do not assume that a hard Brexit ends up tipping Italy into crisis.

If, however, you assume (and Deutsche admits this is “arbitrary”) that “euro-area private domestic demand suffers a shock equivalent to three quarters of the 2011-2012 crisis peak-to-trough declines and — unlike 2011-2012 — looser fiscal policy and weaker exports, an Italy crisis could reduce euro-area GDP by a further 1.3pp over 2019-2021.”

The really interesting bit from the bank’s analysis comes when Deutsche posits a scenario where an inflationary food shock drives up CPI in China and compels the PBoC to tighten policy. Currently, markets are hyper-focused on what China will do to ease policy going forward in an effort to mitigate the effects of the trade war and indeed, Barclays was out last week predicting an “imminent” benchmark rate cut designed to unclog the transmission channel in an effort to ensure that recent measures (RRR cuts and targeting easing) finally manifest themselves in looser credit conditions for borrowers.

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But Deutsche reminds you that “in the past 30 years China has experienced several episodes of high inflation [and] all of these episodes were caused by food price shocks such as swine flus which were hard to forecast.” Each time, the PBoC responded not to core, but to headline CPI in the course of hiking benchmark rates.

“High inflation is obviously a tail risk as the economy is slowing down [and while] a supply shock to inflation is rare, it cannot be ruled out either”, the bank cautions.

The resultant policy tightening against a backdrop of extreme leverage could prove to be a toxic mix.

“A drop in the GDP growth rate 3% below our baseline expectation of 6% in 2019 (and an even greater slowing from 6.6% in 2018) would be a major slump or growth crisis”, Deutsche writes, adding that by comparison, “China’s growth slowed by 4-1/2 percentage points from 14.2% in 2007 to 9.7% in 2008 due to domestic policy tightening and the global financial crisis.”

(Deutsche Bank) 

Clearly, that kind of growth shock in China would reverberate globally. In fact, on Deutsche’s models, it would hit growth in the US, Europe and Japan by “a percentage point or more”, ultimately forcing “monetary authorities in the US and Europe [to] ease policy, with the Fed cutting rates and the ECB moving to a stronger form of longer-term refinancing, an extension of forward guidance and potentially a new round of private asset purchases.”

For context, here is the breakdown of what each shock would entail for global GDP versus DB’s baseline:

(Deutsche Bank)

It goes without saying (or at least it certainly should) that these are not anyone’s base case scenarios. That’s why they are “tail risks”. Still, attempting to quantify the likely fallout should things go “wrong” is especially useful in the current environment given that so much of this is entirely avoidable.

Brexit and the trade war are contrived. They are the product of populist politics run amok and are thus reversible, assuming the necessary political will. The economic situation in China would be tenuous on its own, but clearly, the trade war has made things immeasurably more complicated for Beijing.

Hopefully, hardliners in the US and the UK will eventually realize that what they are pursuing on trade and Brexit, respectively, is a fool’s errand of epic proportions with the potential to cause considerable economic suffering and hardship for millions of people the world over.

And on that note, we’ll leave you with one final passage from the Deutsche Bank piece:

Finally, in response to a much-lower probability of a combination of all three of these shocks, the world economy could face a downturn rivaling that which occurred during the great recession a decade ago.