While most experts are calling for modest economic growth around the world in 2018, there are a number of risks this year that can potentially derail capital markets at home and abroad, says the president and CEO of the Investment Industry Association of Canada (IIAC).

Ian Russell told the Empire Club of Canada in early January that there are three main issues that could disrupt economies over the next year: market fragmentation, shortage of liquidity and a potential, but significant shock.

“A decade out of the financial collapse, the capital markets are healthy, but they have within them inherent risks,” Russell said.

When it comes to fragmentation, Russell said individual jurisdictions, at home and away, have different rules for similar market activities that can lead to regulatory arbitrage and make it difficult for financial institutions to conduct business.

Duplication complicates trade and investment, he said, noting the global over-the-counter (OTC) derivatives market. Following the 2008 financial crisis, he said G20 leaders agreed to improve the integrity of OTC trading and clearing, but didn’t co-ordinate the rules with each other.

Russell pointed out that in contrast to most of the rest of the world, global regulatory co-operation runs second to putting America first in the United States.

“The Treasury has urged U.S. regulatory bodies to try to shape regulatory standards to meet domestic objectives rather than global concerns – the beginning of two distinct regulatory tracks, in which the U.S. moves in the opposite direction to its principal trading partners,” he said.

While the U.S. Federal Reserve Board has signalled its interest in pursuing global regulatory goals with international organizations like the Financial Stability Board, they’ve been resisted by members of the U.S. Congress.

Protectionism

Protectionism is also on the rise, especially in the post-Brexit world, said Russell. U.K. officials may create a new regulatory framework as they leave the EU, steering away from EU regulations.

Russell said Canada has taken a major step away from fragmentation by setting up the Cooperative Capital Markets Regulatory System. But he did note that only five provinces and one territory have agreed to sign on.

Liquidity risk

With investors only buying products they are sure they can sell, the second threat to capital markets is the risk of illiquidity, said Russell. This situation is particularly noticeable when markets are stressed and large dealers hold back from major dealing activity.

The third risk deals with sudden shocks to the financial system. Russell said financial markets are becoming increasingly vulnerable to this shock because a large number of investors are putting them money into exchange-traded funds, “buying the market rather than individual companies.”

The concentration of holdings in these index-linked products is exposed to rising inflation rates, a change in the direction of monetary policy and major geo-political events.

“The consequent downward asset price adjustment could be faster, more correlated and more intense than adjustments in markets driven by fundamental factors,” he said. “The potential is there for an unprecedented herd mentality, leaving market-makers with limited scope to absorb panic selling.”

Russell said the way to guard against all the risks is to increase regulatory co-ordination. In Canada, the Financial Consumer Agency of Canada has entered into an information-sharing agreement with the Investment Industry Regulatory Organization of Canada (IIROC) and Ontario has set up the Financial Services Regulatory Authority that will develop regulations for the insurance industry and other financial institutions in the province.

He also said the Canadian Securities Administrators (CSA) has made “great strides” in strengthening rules for advisors and the transparency of the investment process. “Regulators outside the domestic investment industry should take note.”

Regulation requires a careful, disciplined approach and the need to find ways to lessen a systemic market impact. “We may need to strengthen the underpinnings of …[financial] institutions, notably some of the large asset managers, through increased liquidity cushions and tighter leverage requirements.”

Meanwhile, David Rosenberg, chief economist at Gluskin Sheff & Associates, noted that North America is in its second longest expansion period ever, now in its 103rd month.

Virtually every asset class performed well in 2017, including global bonds that racked up an annual return of 7.5 per cent – and was considered the worst performer, said Rosenberg.

North America is in the last stages of this cycle and investors may want to take a look at the remaining 60% of the international market and its $40 trillion worth of assets.

An eye on Japan

Rosenberg said he believes Japan is the country to keep an eye on this year. Asleep for a long time, Japan is now out of recession and out of deflation under Prime MinisterShinzo Abe. Its aging population is being replaced by a growing number of women entering the labour force as well as foreign immigration.