What will cause the next Financial Crisis?
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As the weekend saw numerous post mortems marking the 10 year anniversary of the Lehmans crash and the moment the GFC started to fully play out, we came across an opinion piece on MarketWatch.com by Howard Gold. Whilst acknowledging no one individual fully connected all the dots that precipitated the crisis, he highlighted 4 who got it more right than most and interviewed each. We present below their respective warnings about what will bring on the next market crash.
• Economist A. Gary Shilling warned his newsletter subscribers about a housing bust and wholesale deleveraging of household debt that would hobble the economy for years.
> ““The ultimate thing that brings down financial markets is excess leverage … So, you look where’s the big leverage, and right now I think it’s in emerging markets.”
Shilling is particularly worried about the $8 trillion in dollar-denominated emerging-market corporate and sovereign debt, especially as the U.S. dollar rises along with interest rates. “The problem is as the dollar increases,” he said, “it gets tougher and tougher for them to service [that debt] because it takes more and more of their local currency to do so.” Of that, $249 billion must be repaid or refinanced through next year, Bloomberg reported.”
• Money manager James Stack also told his clients the housing bubble had burst and that a new bear market was coming—while stocks were hitting all-time highs.
> “Stack indicates that housing-related stocks “saw a parabolic run-up” in 2016-17, but in January his index “peaked and now it’s coming down hard.” That suggests “bad news on the housing market looking 12 months down the road,” he said.
But the biggest danger, Stack told me, is from low-quality corporate debt. Issuance of corporate bonds has “gone from around $700 billion in 2008 to about two and a half times that [today].”
And, he added, more and more of that debt is subprime. Uh-oh.
In 2005, he pointed out, companies issued five times as much high-quality as subprime debt, but last year “we had as much subprime debt, poor quality-debt issued, as quality debt on the corporate level,” he said, warning “this is the kind of debt that does get defaulted on dramatically in an economic downturn.””
• Raghuram Rajan, then chief economist of the International Monetary Fund, said the amount of risk and leverage in the system was much higher than most people thought.
> “Rajan believes “there has been a shift of risk from the formal banking system to the shadow financial system.” He also told me the post-crisis reforms did not address central banks’ role in creating asset bubbles through accommodative monetary policy, which he sees as the financial markets’ biggest long-term challenge.
“You get hooked on leverage,” he said. “It’s cheap, it’s easy to refinance, so why not take more of it? You get lulled into taking more leverage than perhaps you can handle.”
Rajan also sees potential problems in U.S. corporate debt, particularly as rates rise, and in emerging markets, though he thinks the current problems in Turkey and Argentina are “not full-blown contagion.”
“But are there accidents waiting to happen? Yes, there are.””
• John Mauldin said a housing bust would lead to a drop in consumer spending, a bear market, and a recession (though at first he thought it would be a mild one), and that credit default swaps (CDSs) posed a systemic risk.
> “Mauldin estimates the world has almost “half a quadrillion dollars,” or $500 trillion, in debt and unfunded pension and other liabilities, which he views as unsustainable.
But the flashpoint for the next crisis is likely to be in Europe, especially Italy, he maintains.
“I think the choice of Europe is…going to have to put [all the debt] on the balance sheet of the European Central Bank,” he said. “If they don’t, then the euro zone breaks apart and we’re going to get a 50% valuation collapse.”
“Greece,” he said, “is a rounding error. Italy is not…. And Brussels and Germany are going to have to allow Italy to overshoot their persistent debt, and the ECB is going to have to buy that debt.
If it doesn’t happen, the debt triggers a crisis in Europe, [and] that triggers the beginning of a global recession”
But, he added, “there are so many little dominoes, if they all start falling, one leads to the next.”
The U.S. economy and markets are doing very well now, but make no mistake—there will be another crisis. Your guess on where or when it will happen is as good as mine.”
For us the takeaway from these collective thoughts just reinforces what we say time and again…. No one knows what will happen next nor when. Balance, real uncorrelated balance, is vital to protect your wealth. This market may well go much higher. It could also see a 50-80% fall tomorrow. Just late last week Nobel prize winner and co-creator of the Shiller P/E Index, Robert Shiller expressed:
"It has something to do with our president, who is an exceptionally business-oriented president and who wants to deregulate and favors lower taxes," he said. "That has an effect on the market but it goes beyond the rational, logical effect - it has something to do with our animal spirits. The U.S. is just doing great right now in terms of the strength of the economy and the stock market. That seems to be built around the Trump story at this point in history”…... "The stock market could get a lot higher before it comes down. It’s highly priced, but it could get much more highly priced. It’s a risky market now,"
What the learned opinions expressed above all highlight is that on any account we are in risky times but the risks are not clearly in one sector, country or region – but they are inextricably linked. What they have in common is DEBT. Debt is one of those clearly quantitative metrics that can’t be ‘opinioned’ away and is shared globally. Excess debt has and always will have a day of reckoning. Hence our trademark – “Balance your wealth in an unbalanced world”.