Trade tension and geopolitical uncertainty raise systemic market risks: Moody’s

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In a report released Wednesday, Moody’s Investors Service has highlighted heightened trade tensions and political uncertainty in Europe and the Middle East as increasing systemic risks in financial markets. The agency noted that risks do remain moderate overall, however.

Market liquidity has tightened alongside rising volatility in equity markets, and capital inflows generally remain lackluster across most emerging markets, the agency said. The damage caused by the next credit downturn will also be exacerbated by elevated private leverage.

Trade tensions in May led to a fall in the equity markets, before a rebound in June following indications that central banks would begin easing interest rates. Moody’s noted that equity prices are still elevated on some metrics, including price-to-earning ratios, but these ratios may be understating the impact on lower real interest rates.

“We expect that ongoing trade tensions and political uncertainty will keep equity markets volatile. Equity prices still look elevated on some traditional metrics, but these may understate the impact of structurally lower real interest rates,” said Colin Ellis, Moody’s managing director for credit strategy and co-author of the report.

The bond market has been, in contrast to equities, calmer overall. However, investors have reassessed the overall economic outlook with long-term government bond yields declining in higher-rated advanced economies in tandem.

“Policy rate expectations in the US Treasury bond market have been swiftly revised since the beginning of the year. The market is now pricing in more cuts in the US policy rate than Federal Open Market Committee (FOMC) members suggested in June,” added Ellis. “While a disconnect between the bond market and FOMC projections has occurred before, the resolution of this misalignment could generate bond market volatility.”

The agency also noted that the supply of safe assets, whilst steady, has become increasingly concentrated in US Treasury bonds. Worryingly, the proportion of supply of Aaa-rated government bonds is at 2008 levels, even despite a deterioration in sovereign credit quality and central bank purchases.

“However, the lower number of Aaa-rated issuers and the increase in US Treasury bond issuance means that US Treasuries now account for around 75 percent of all Aaa-rated government bonds available, up from 50 percent in 2008. In addition, banks’ low profitability constrains their ability to cope with the next downturn,” Moody’s said in a statement.