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The Next Financial Crisis

By David Scott | Monday 17 December 2018


 


Dec 2018
 
I have a lot of sympathy for the position that many investors find themselves in and that is the fear of missing out. It is a big driver and keeps people at the party far too long.
 
We are in late cycle economics. Consumers are tired and over-borrowed. Companies have extracted all the margin they can and have leveraged themselves as well. Cheap money has spawned competition that if the price of money were set correctly and we had creative destruction, many Zombie companies simply fail helping boost terrible productivity numbers for the economy. Against this growing populism risks playing about with prices and property ownership. A recession should not be altogether unwelcome given that they deal with the problem of rich and poor and young and old. The rich lose money which pleases the poor. The old lose their jobs and the young are the first to be reemployed. Without recessions this redistribution has to be done through taxation and legal theft which creates social divided and political bitterness.
 
Remove the crutches that have supported global growth for a decade, throw in a trade war between the world’s two largest economies, add a dash of wage inflation and a side dish of Brexit and you have a recipe that may prove rather unpalatable to global markets in 2019. The party is coming to an end. For 10 years, central banks fuelled the good times with a combination of low interest rates and quantitative easing to boost the global economy following the financial crisis of 2007-08. It was a period of unconventional monetary policy that lasted much longer than virtually all experts predicted, leaving global markets with a bigger hangover than anticipated. In the last four months, markets seem finally to have woken up to this new dawn of fading central bank support. Investors seem unsure how the global economy will fare in a higher interest rate environment sparking the market volatility we have seen across both the equity and bond markets.
 
The US economy in particular is under scrutiny with growth supported presently by Donald Trump’s $1.5 trillion package of tax cuts which delivered sizeable reductions in both corporate and individual tax rates. The issue, of course, remains the pick-up in US wage growth due to tight labour market conditions. The unemployment rate, at 3.7%, is at its lowest level since December 1969 while wages recorded their largest annual gain in 9½ years in October 2018. In this context, I would expect the US Federal Reserve to continue its policy of measured interest rate rises, in part also to offset the increase in the US budget deficit coming down the line.
 
Europe’s economy will muddle along, possibly delivering just enough for the European Central Bank to be able to raise interest rates next year for the first time since 2011, as the ‘Italian question’ hangs over the euro zone. The country’s populist government has clashed with European authorities over its plans to boost spending in its 2019 budget; the move is viewed as reckless given Italy’s outstanding public debt has reached around 133% of GDP, far higher than any of the other major euro zone nations. A stand-off between Italy and the EU could lead to a full-blown crisis that would have the capacity to break up the euro zone.
 
One of the biggest challenges is the intensifying rivalry between China and the US, the world’s two economic superpowers. Given the unpredictability of the current incumbent at the White House, it is difficult to say whether trade war tensions will escalate or ease in 2019. We do know however that a continuation of relatively frictionless global trade ultimately determines the economic wellbeing of the rest of the world. Emerging market economies in particular have been great beneficiaries of free trade so this new wave of protectionism, backed by a resurgence in nationalism, could prove damaging.
 
Source - Houseman

What Leads to a Financial Crisis? There are primarily three factors.
 
The next crisis, however, will find central banks with almost no real tools to disguise structural problems with liquidity and no fiscal space in a world where most economies are running fiscal deficits for the 10th consecutive year, and global debt is at all-time highs. The next crisis, like 2007-2008, will be blamed on a symptom (Lehman in that case), not the real cause - aggressive monetary policy incentivising risk-taking and penalizing prudence.
 
Governments and central banks saw rising markets above fundamental levels and record levels of debt as small but acceptable problems in the quest for a synchronized growth that was never going to happen. The risks are obviously difficult to analyse because the world entered into the biggest monetary experiment in history with no understanding of the side effects and real risks attached a widespread zombification of global economies to avoid the pain of a large repricing of sovereign bonds, which leads to massive tax hikes to pay the rising interests, economic recession, and unemployment. The next crisis is not likely to be another Lehman, but another Japan. When the biggest bubble is sovereign debt, the crisis we face is not one of the massive financial market losses and real economy contagion, but a slow fall in asset prices - as we are seeing - and global stagnation. In my opinion. Contagion is much more difficult because there have been some lessons learned from the Lehman crisis. There are stronger mechanisms to avoid a widespread domino effect in the banking system.

What Will the Next Financial Crisis Look Like?
 
In 2017 it was accelerated by the incorrect belief that emerging markets were fine because their stocks and bonds were soaring despite the Federal Reserve interest rate normalization. The 2007 crisis erupted because in 2005 and 2006 even the most prudent investors gave up and surrendered to the rising-market. The fallacy of synchronized growth triggered the beginning of what could lead to the next recession - a generalized belief that monetary policy had been very effective, growth was robust and generalized and debt increases were just collateral damage but not a global concern. With the fallacy of synchronized growth came excess complacency and acceleration of imbalances. When the biggest driver of asset price inflation - central banks - starts to unwind or simply becomes part of the expected liquidity - like in Japan - the placebo effect of monetary policy on risky assets vanishes and losses pile up.
 
The historical analysis of losses is contaminated by the massive impact of monetary policy actions in those years. When markets fall, they fall in tandem, as we are seeing when assets reach an abnormal level of correlation and volatility is dampened due to massive central bank asset purchases, the analysis of risk and probable losses is simply ineffective. This is simply a myth. That “massive liquidity” is just leverage, and when margin calls and losses start to appear in different areas - emerging markets, European equities, U.S. tech stocks - the liquidity that most investors count on to continue to fuel the rally simply vanishes. Why? Because value at risk is also incorrectly calculated. The incorrect perception of liquidity and value at risk. Years of high asset correlation and synchronized bubble spearheaded by sovereign debt have led investors to believe that there is always a massive amount of liquidity waiting to buy the dips to catch the rally. Sovereign debt. The riskiest asset today is sovereign bonds at abnormally low yields, compressed by central bank policies. With $6.5 trillion in negative-yielding bonds, the nominal and real losses in pension funds will likely be added to the losses in other asset classes.

What Are Immediate Triggers of the Next Financial Crisis?
 
The 2007–2008 crisis did not start because of Lehman; it was just a symptom of a much wider problem that had started to cause small bursts months before - excess leverage to a growth cycle that fails to materialize as the consensus expected. Bubbles do not burst because of one catalyst, as we are taught to believe and the third factor, the realization that this time is different. It is impossible to build a bubble on an asset where investors and companies see an extraordinary risk. It must happen under the belief that there is no risk attached to rising valuations because “this time is different,” “fundamentals have changed” or “there is a new paradigm,” sentences we have all heard more times than we should in the past years. Excessive risk-taking in assets that are perceived as risk-free or bullet-proof. Second, complacency and excess risk-taking cannot happen without the existence of a widespread belief that there is a safety net, a government or central bank cushion that will support risky assets. Terms like “search for yield” and “financial repression” come precisely from artificial demand signals created from monetary and political forces citizens to believe that there is no risk. First, demand-side policies that lead investors and 

When will it happen?

We do not know, but if the warning signs of 2018 are not taken seriously, it will likely occur earlier than expected. However, the governments and central banks will not blame themselves; they will present themselves - again - as the solution.


The great Chinese growth slowdown has been proceeding in stages for the past two years. The reason is simple. Much of China’s “growth” (about 25% of the total) has consisted of wasted infrastructure investment in ghost cities and white elephant transportation infrastructure. That investment was financed with debt that now cannot be repaid. This was fine for creating short-term jobs and providing business to cement, glass and steel vendors, but it was not a sustainable model since the infrastructure either was not used at all or did not generate sufficient revenue. China’s future success depends on high-value-added technology and increased consumption. But shifting to intellectual property and the consumer means slowing down on infrastructure, which will slow the economy. In turn, that means exposing the bad debt for what it is, which risks a financial and liquidity crisis. China started to do this last year but quickly turned tail when the economy slowed. Now the economy has slowed so much that markets are collapsing. But doesn’t China have over $1 trillion of reserves to prop up its financial system?
 
On paper, that’s true. But in reality, China is “short” U.S. dollars. The Chinese may have $1.4 trillion of U.S. Treasury securities in its reserve position, but they need those assets possibly to bail out their banking system or defend the yuan. Meanwhile, the Chinese banking sector, which in many ways is an extension of the state, owes $318 billion in U.S. dollar-denominated deposits of commercial paper. From a bank’s perspective, borrowing in dollars is going short dollars because you need dollar assets to back up those liabilities if the original lenders want their money back. For the most part, the banks don’t have those assets because they converted the dollar to yuan to prop up local real estate Ponzis and local corporations. There’s not much left over to bail out the corporate, individual and real estate sectors. This is all part of a global “dollar shortage” attributable to Fed tightening, both in the forms of higher rates but also a reduction in base money. A dollar shortage seems implausible in a world where the Fed printed $4.4 trillion. But while the Fed was printing, the world borrowed over $70 trillion (on top of prior loans), so the dollar shortage is real. The math is inescapable.

So the Chinese debt bomb that has been a long time in the making is finally getting ready to explode. The economy is slowing, debt is exploding and the trade war with Trump has hurt China’s exports needed to earn dollars to pay the debts. The defaults are beginning to pile up. Several large corporations and regional governments have defaulted recently. China’s leaders have panicked at the slowdown and have started the credit flow again with lower interest rates, higher bank leverage and more debt-financed, government-directed infrastructure spending. Of course, this solution is strictly temporary. All it does is postpone the day of reckoning and make the debt crisis worse when it does arrive. With every passing day, a Chinese financial reset draws closer. The rest of the world will not escape the consequences.
Source - Pantheon Economics

As the EU pressures Italy to retreat from a deficit of 2.4% of GDP next year, the promises Macron unveiled Monday night, from a 100-euro ($114) a month hike in the minimum wage to abolishing a tax on pensions, are expected to cost around EUR 10 billion (or 0.5ppt of GDP), which, as French Budget Minister Gerald Darmanin indicated, will send the 2019 budget to a deficit at 3.4% of GDP. That is worse that Italy's.

Over the course of the past decade, the global economy has recovered from the 2008 financial crisis by riding a wave of debt and liquidity injections from the major central banks. Yet in the absence of steady wage growth and productive investments in the real economy, the only direction left to go is down.
 
When Lehman Brothers declared bankruptcy ten years ago, it suddenly became unclear who owed what to whom, who couldn’t pay their debts, and who would go down next. The result was that interbank credit markets froze, Wall Street panicked, and businesses went under, not just in the United States but around the world. With politicians struggling to respond to the crisis, economic pundits were left wondering whether the “Great Moderation” of low business-cycle volatility since the 1980s was turning into another Great Depression. In hindsight, the complacency in the run-up to the crisis was clear and yet little has changed in its aftermath. We are told that the financial system is simpler, safer, and fairer. But the banks that benefited from public money are now bigger than ever; opaque financial instruments are once again rife and bankers’ bonus pools are overflowing. At the same time, un- or under-regulated “shadow banking” has grown into a $160 trillion business. That is twice the size of the global economy. Thanks to the trillions of dollars of liquidity that major central banks have pumped in to the global economy over the past decade, asset markets have rebounded, company mergers have gone into overdrive, and stock buybacks have become a benchmark of managerial greatness.
 
By contrast, the real economy has spluttered along through with bouts of optimism and intermittent talk of downside risks. And while policymakers tell themselves that high stock prices and exports will boost average incomes, the fact is that most of the gains have already been captured by those at the very top of the pyramid. These trends point to an even larger danger: a loss of trust in the system. Adam Smith recognized long ago that perceptions of rigging will eventually undermine the legitimacy of any rules-based system. The sense that those who caused the crisis not only got away with it, but also profited from it has been a growing source of discontent since 2008, weakening public trust in the political institutions that bind citizens, communities, and countries together. During the synchronized global upswing last year, many in the economic establishment spoke too soon about sustainability. With the exception of the US, recent growth estimates have fallen short of previous projections, and some economies have even slowed. While China and India remain on track, the number of emerging economies under financial stress has increased.
 
As the major central banks talk up monetary-policy normalization, the threats of capital flight and currency depreciation are keeping these countries’ policymakers extremely nervous. The main problem is not just that growth is tepid, but that it is driven largely by debt. By early 2018, the volume of global debt had risen to nearly $250 trillion – three times higher than annual global output – from $142 trillion a decade earlier. Emerging markets’ share of the global debt stock rose from 7% in 2007 to 26% in 2017, and credit to non-financial corporations in these countries increased from 56% of GDP in 2008 to 105% in 2017. In addition, the negative consequences of tightening monetary conditions in developed countries will become more severe, given the disconnect between asset bubbles and recoveries in the real economy. While stock markets are booming, wages have remained stuck. And despite the post-crisis debt expansion, the ratio of investment-to-GDP has been falling in the advanced economies and plateauing in most developing countries.
 
There is a very big “known unknown” hanging over this fragile state of affairs. US President Donald Trump’s trade war will neither reduce America’s trade deficit nor turn back the technological clock on China. What it will do is fuel global uncertainty if tit-for-tat responses escalate. Even worse, this is occurring just when confidence in the global economy is beginning to falter. For those countries that are already threatened by heightened financial instability, the collateral damage from a disruption to the global trading system would be significant and unavoidable. This is not the beginning of the end of the post-war liberal order. The unravelling of that order started long ago, with the rise of free hot capital, the abandonment of full employment as a policy goal, the delinking of wages from productivity, and the intertwining of corporate and political power. Against this trade wars are best understood as a symptom of unhealthy hyper-globalization.
 
In addition, emerging economies are not the problem. China’s determination to assert its right to economic development has been greeted with a sense of disquiet, if not outright hostility, in many Western capitals. But China has drawn from the same standard playbook that developed countries used when they climbed the economic ladder. China’s success is exactly what was envisioned at the 1947 United Nations Conference on Trade and Employment in Havana, where the international community laid the groundwork for what would become the global trading system. The big issue is really how far the current multilateral order has moved from its original aims. The Lehman crisis did initially trigger a revival of the post-war multilateral spirit; but it proved very short lived, the tragedy of our times is that just when bolder cooperation is needed to address the inequities of commercial hyper-globalization, the voice of “free trade” has been drowned out the calls of those calling for a restoration of trust, fairness, and justice in the system. Without trust, there can be no cooperation.
Source - Department for Business, Energy & Industrial Strategy
Source - Citi

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne


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