By Mike Riddell, portfolio manager of the Fidelity Strategic Bond fund

October saw the semi-annual meeting of the International Monetary Fund (IMF) and World Bank, where the world’s central bankers and finance ministers gathered to discuss the most crucial issues of the day. One of which was the worrying reemergence of global imbalances.

Global imbalances became a hot topic in the run up to the global financial crisis (GFC) in 2008, when academics and policymakers tried to understand why the US was running an increasingly large current account deficit, and what the implications were. A current account deficit is a broader measure of a trade balance – when a country is importing more than it is exporting, it must attract investment from overseas to fund this difference.

Pre-GFC, most had believed the US current account deficit was almost entirely the product of excessive US domestic spending. But Ben Bernanke argued in 2005 that countries outside of the US were just as guilty of contributing to imbalances since they were saving too much. He described this as a ‘global savings glut’ where companies and investors outside of the US were too risk averse to spend capital domestically, so instead sought to save via purchasing US assets.

This ‘glut’ particularly came from Asia and emerging markets, where the situation was exacerbated by policymakers often deliberately intervening to maintain cheap exchange rates, which thereby increased their FX reserves, where these reserves would then be recycled back into US dollar assets.

See also: Mike Riddell on income: Keep calm and carry on

It is natural for younger and faster growing economies to run current account deficits, and more mature economies to run surpluses. Traditionally, emerging markets have tended to run modest deficits as a result.

But excessive current account deficits aren’t sustainable for a prolonged period. A vast body of academic literature has argued that when an economy is overly reliant on money from overseas, it risks the dangerous possibility of a balance of payments crisis, where the capital inflows come to a sudden stop, igniting financial crises.

The bad news is that global imbalances are back. And these days, the US makes up almost the entirety of the deficit side of the global imbalance, acting as the go-to destination for foreign and domestic capital. The only other major economies experiencing deficits are the UK, Brazil and Australia, although these countries’ balance of payments positions are modest versus their own histories. The US current account deficit has been running at around 4.5% of US GDP this year, which is the equivalent to more than 1% of global GDP.

The IMF raised their concern over imbalances earlier this year. I have updated their work below to show how global imbalances have materially worsened since then.

The most likely explanation for these worrying imbalances is that the US government is running unsustainable fiscal policy, which is causing an excess of US investing over savings. A US current account deficit that’s back to pre-financial crisis levels is also indicative of an overvalued US dollar exchange rate, and symptomatic of a US asset price bubble given that a substantial portion of the US deficit is being funded by portfolio flows into US bonds and equities. Meanwhile China’s policy of export driven growth is likely exacerbating the surplus side too.

As ever, it’s difficult to know what the trigger might be for these unsustainable US deficits to normalise. A country running a twin (current and fiscal) deficit is, as Mark Carney once said, ‘reliant on the kindness of strangers’. If US policies continue to antagonise these strangers, then the result will surely be a substantial and rapid depreciation of the US dollar, probably coupled with sharp US asset price falls.

Alternatively, the US could pursue a policy of currency weakness, which would be a less dramatic way of achieving a rebalance. Economic policy changes in the US such as cutting government spending and increasing taxes would help. China could also reduce global imbalances by encouraging more domestic spending. But a U-turn in current policies from either country seems unlikely at present. The US imposing tariffs on trade partners will not fix this problem, since it will likely cause both US imports and exports to drop.  

In our funds, we continue to avoid US assets, due in part to fears of a waning in global demand for US assets, but also because of expensive valuations. We are short the US dollar and US high yield credit, and have less exposure to US Treasuries than our benchmark. Against this, we have been buying emerging market currencies and sovereign debt, which we feel is far more attractively valued.