Navigating the Global Financial Landscape: A Year of Improved Conditions and Increased Risk Appetite

The global economic and financial environment has seen significant improvements over the past year, with a decline in inflation in advanced economies and a reduced risk of a major recession. However, geopolitical tensions have also increased, adding a layer of uncertainty to the overall picture.

Investors’ appetite for risk has increased, driving up the prices of various financial assets and reducing risk premiums and credit spreads in both Canada and the United States. Benchmark equity indexes in both countries have reached all-time highs, and corporate credit spreads are at or below levels seen since the global financial crisis of 2008-09.

While volatility and liquidity in bond markets have improved, they remain higher and lower, respectively, than before central banks began increasing their policy rates. Despite these improvements, uncertainty remains high, with factors such as inflationary pressures and geopolitical tensions posing potential risks to the global financial system.

In Canada, the financial system has remained resilient, with participants taking steps to enhance their resilience in the face of higher interest rates. Actions such as reducing demand for credit, increasing provisions for loan losses, and strengthening liquidity risk management processes have helped mitigate risks to individual borrowers and lenders as well as overall financial stability.

However, risks to debt serviceability could affect the performance of lenders’ credit portfolios, as some households show signs of financial stress. Higher debt-servicing costs could reduce financial flexibility and increase vulnerability in the event of an economic downturn.

Valuation risks could also lead to corrections in asset prices and market strains, especially if expectations around interest rates or the economic outlook change significantly. Asset managers may face losses and liquidity needs from redemptions or margin calls, potentially leading to forced deleveraging and market liquidity strains.

Interconnections in the financial system could transmit stress, amplifying the impact of any shock and leading to system-wide stress. While banks are well capitalized and have sufficient liquidity buffers, a large-scale liquidity event could cause widespread actions to enhance resilience, potentially leading to secondary effects such as asset fire sales.

Participants in the financial system are urged to continue planning for more adverse outcomes, building adequate loss-absorption and liquidity buffers to ensure resilience. Proactive planning by households, businesses, and banks is essential to maintaining stability and preserving financial health for all Canadians.