Where Will The Next Crisis Come From?
It’s been 10 years since a U.S. financial shock turned into a crisis in the global financial, market and economic system.
A shock turns into a crisis when the system is unprepared for it. The system is often at its most vulnerable near the end of the global economic cycle when excesses have built up and managing risks may have been neglected.
The global economic, financial and market system now seems better prepared to manage the shocks of the past were they to repeat in the future. But there are other increased vulnerabilities including: high debt levels, political fragmentation, dependence on international sales, little fiscal or monetary policy ammunition, and the rise of passive investments.
It’s been 10 years since a U.S. financial shock turned into a crisis in the global financial, market and economic system. On September 15, 2008, Lehman Brothers filed for bankruptcy as the shock waves from subprime mortgages rocked the entire financial system, shattering confidence and leading to an economic downfall.
Regularly paying attention to financial news reveals one thing for certain: shocks to the global system happen all the time. Many of these shocks are absorbed by the system without much disruption. Recent examples of shocks might include last year’s escalating geopolitical tensions between the U.S. and North Korea, the U.S. Fed beginning to reverse QE (quantitative easing), or the rapid unwinding of the short-volatility trade that took place earlier this year.
A shock turns into a crisis when the system is unprepared for it. The system is often at its most vulnerable near the end of the global economic cycle when excesses have built up and managing risks may have been neglected. Since we have likely reached the later stages of the cycle, it is now a good time to assess how well the system is prepared for the shocks that lie ahead and where the biggest vulnerabilities may lie.
Hundreds of shocks turned into relatively few crises that hit stocks
Source: Charles Schwab, Bloomberg data as of 8/16/2018.
Better prepared for some shocks
The global economic, financial and market system now seems better prepared to manage the shocks of the past were they to repeat in the future thanks to: stable energy supplies, low inflation, “circuit breakers”, few fixed exchange rates, a lack of extreme valuations, lots of corporate cash, and stronger banks.
1. Stable energy supplies – A frequent source of shocks that the system has been vulnerable to in the past has been abrupt shifts in the supply of oil: the Arab oil embargo in 1973, Iraq’s invasion of Kuwait in 1990 and the U.S. shale oil boom in 2014-15. Each of these lead to very big moves in the price of oil, up or down. Fortunately, today’s increased economic efficiency with regard to oil, as you can see in the chart below, and the growth in non-OPEC supply (notably from the U.S.) would likely have limited the vulnerability of the system to the shocks in 1973 and 1990.
Oil consumption relative to GDP continues to decline
Source: Charles Schwab, World Bank data as of 8/19/2018.
2. Low inflation – Inflation remains low and well-contained on a global basis. Markets reflect a high degree of confidence in central banks to stay ahead of the curve on inflation based on inflation forecasts embedded in bond yields and economists’ forecasts. This marks a stark contrast to soaring inflation among many countries in the 1970s as central banks got behind the curve on inflation. This forced an abrupt shock on a vulnerable global system as the Federal Reserve aggressively hiked rates into the double-digits in 1979-80 to end the cycle of spiraling inflation at the cost of a global bear market and recession.
Inflation (CPI year-over-year % change) for selected countries
Source: Charles Schwab, Bloomberg data as of 8/19/2018.
3. Circuit breakers – The so-called “circuit breakers” would have made the stock market less vulnerable to the selling forces that drove the October 19, 1987 stock market crash where the Dow Jones Industrial Average dropped 508 points, or 22.6%, the biggest one-day decline in the history of the stock market. A similar one-day drop in the Dow today would be almost 6,000 points.
Then, an options technique referred to as “portfolio insurance,” which hedges a portfolio of stocks by short selling stock index futures, depended on the ability to sell more as the market declined. This allowed the drop to feed on itself and overwhelm the trading systems. To avoid such selling pressure in the future, circuit breakers were implemented in 1989 across all exchanges which halt trading for periods of time when the stock market hits certain percentage declines. The periodic “flash crashes” we have seen since then have been reserved to very short intra-day moves.
4. Few fixed exchange rates – The fixed exchange rate regimes that fed the 1998 Asian crisis have all but completely vanished. A major difference between the Asian crisis of 1998 and today is that most emerging markets (EMs) have floating rather than fixed exchange rates, limiting a vulnerability to shocks. Floating exchange rates mean that shocks can be absorbed over time instead of hitting suddenly when multiple currencies devalue by a large amount all at once as we saw in Asia during the fall of 1998. Also, EM current accounts are now in balance, on average, rather than in deficit as they were in 1997-98 when they were dependent upon foreign lending to sustain their trade deficits, as you can see in the chart below. Finally, EMs have much greater foreign currency reserves that can be used to defend their currencies than they did 20 years ago.
Current accounts in balance
Nine crisis-prone countries included in average: Brazil, India, Indonesia, Malaysia, Mexico, Russia, South Africa, Thailand, and Turkey.
Source: Charles Schwab, International Monetary Fund data as of 8/19/2018.
5. Valuations not at extremes – There are many measures of stock market valuations. On balance, those valuations are above average, as is typical after an extended period of growth, but not at extremes or as broadly above average as they were in 2000. Extreme valuations make the market vulnerable to a shock in the form of missing lofty expectations. Both the higher level of valuations and the number of industries that had extreme valuations in 2000 compared to today can be seen in the chart below. The economic vulnerability to the 2000 shock was increased by how much investment had poured into intangible goodwill as opposed to productive assets as the valuation bubble inflated.
Valuation comparison by industry: March 2000 peak and July 2018
Price-to-earnings ratio on next twelve months earnings estimates for each of the 66 industry groups that make up the MSCI AC World Index for March 2000 and July 2018. The two industry groups with PEs exceeding 100 appear at top of scale.
Source: Charles Schwab, Factset data as of 8/18/2018.
6. Lots of corporate cash – Companies have lots of cash relative to history according to data compiled by Bloomberg. This lack of a vulnerability, in our view, that in the past has led to the need for forced sales of assets to support companies’ core businesses may help keep a shock from developing into a crisis. It also suggests the potential for corporate share buybacks that might limit the vulnerability of stock prices to investor selling pressure.
7. Stronger banks – In our opinion, banks are less vulnerable today than they were ahead of the 2008-09 financial crisis and the 2012 European debt crisis. Most importantly, there has been a reduction in risky activities, including sub-prime mortgage lending. There have also been substantial regulatory and institutional changes which aim to address some of the systemic weaknesses that contributed to the global financial crisis, these include: the establishment of new regulatory institutions, bank stress tests and increased capital requirements, bank taxes and fees, “bail-in” provisions, increased savings protection, and altered incentive structures. There is further progress to be made, especially in Europe where the banking system is still not integrated. But it’s clear that on measurable benchmarks banks are much better prepared. For example, banks are much better capitalized than in 2008-09 and 2011-12 crises with Tier 1 capital ratios considerably higher than they were going into past crises, as you can see in the chart below.
Domestic banks Tier 1 capital to risk-weighted assets
Source: Charles Schwab, Bloomberg data as of 8/15/2018.
Increased vulnerability to other shocks
The global economic, financial and market system now seems better prepared to manage the shocks of the past were they to repeat in the future. But there are other increased vulnerabilities that may make future shocks turn into a crisis:
- High debt levels could magnify a shock from higher interest rates.
- Political fragmentation may impair an effective response to a shock.
- Dependence on international sales may mean more vulnerability to a shock from trade conflict.
- Little ammunition left in the form of monetary and fiscal stimulus may limit the ability of policy to mitigate a shock from an economic slowdown.
- Rising inflows into passive investments might amplify the market volatility from a shock.
Let’s look at each of these vulnerabilities.
1. High debt levels – Global debt has swelled to 225% of GDP reaching $164 trillion, nearly $50 trillion above the levels that preceded the financial crisis (data is for 2016—the latest year for which totals from the IMF are available). Debt has grown sharply from $62 trillion in 2001 and $116 trillion in 2007 just ahead of the global financial crisis, as you can see in the chart below.
Global debt has nearly tripled since 2001
Source: Charles Schwab, International Monetary Fund data as of April 2018.
While the International Monetary Fund (IMF) forecasts the U.S. as the only advanced economy that will see a further increase in debt-to-GDP ratio over the next five years, as you can see in the chart below, more than one-third of developed economies have debt-to-GDP levels above 85%--three times worse than in 2000.
IMF expects debt-to-GDP to worsen for the U.S.
Source: Charles Schwab, International Monetary Fund projections as of 4/23/2018.
While a high debt burden isn’t necessarily a problem by itself, it increases the vulnerability of the system to a shock—in particular, a shock that would lift interest rates. Central banks’ QE (quantitative easing) programs helped ease the cost of higher debt burdens by keeping interest rates low, but those programs are winding down.
In theory, all that debt means the potential losses from a rise in interest rates would be more costly than in the past, especially combined with a stronger dollar pushing up the cost of dollar-denominated debt outside the United States. In reality, it is hard to draw hard conclusions as to what impact an interest rate shock would have on the increasingly indebted global economic and financial system due in part to some of that increase in debt being held by central banks that aren’t leveraged or marked to market on their holdings and refund excess interest payments back to the government, unlike traditional financial institutions. For example, U.S. Treasury yields jumped by about one full percentage point and the dollar soared during 2013’s so-called “taper tantrum” without the shock turning into a crisis. Nevertheless, increasingly high debt burdens represent an increased vulnerability to a shock.
2. Political fragmentation - The political establishment has frayed considerably in almost all major economies since the global financial crisis. Populism of both the far right and far left has been on the rise making decision-making, and even assembling governments, harder to do. The U.S. appears to be stepping back from its post-WWII role as a stabilizing force and organizer of global crisis responses. The result may be that the willingness or ability of governments to mount an effective response to a shock is impaired and could lead to a crisis.
3. Dependence on international trade – After a steady rise over many decades, more than half of the sales of the companies that make up the world’s stock market (MSCI World Index) now come from outside their home country, according to Factset data. Even domestic sales are impacted by increasingly interconnected global supply chains resulting in greater vulnerability to shocks from bottlenecks or border issues than in the past.
Companies in most countries get most of their sales from outside their borders
Based on sales of companies in MSCI China Index, MSCI India Index, MSCI USA Index, MSCI Australia Index, MSCI Japan Index, MSCI Canada Index, MSCI Korea Index, MSCI Hong Kong Index, MSCI Taiwan Index, MSCI Switzerland Index, MSCI United Kingdom Index, MSCI France Index, MSCI Germany Index, MSCI Netherlands Index.
Source: Charles Schwab, Factset data as of 8/19/2018.
4. Less ammunition to fight a downturn - There is little room for governments to use increases in public spending or central banks to ease monetary policy in response to a shock in order to fight an economic downturn. The pre-crisis 2007 U.S. budget deficit of $161 billion, or 1.1% of GDP, pales in comparison to this year’s projection of $804 billion, or 4.5% of GDP. In Europe, with the exception of Germany, there is very little room for governments to engage in fiscal stimulus. Quantitative easing has left central bank balance sheets stuffed with nearly $15 trillion in assets (see chart below) and interest rates are still close to record lows—with policy rates still negative in some countries.
Central bank balance sheets have bloated since 2008-09 global financial crisis
Source: Charles Schwab, Bloomberg data as of 8/19/2018.
While a downturn that could require as much stimulus as the financial crisis is unlikely, the vulnerability posed by limited ammunition to fight a downturn could lengthen and deepen the effects of the shock.
5. Rise of passive investing – It is unknown if the rise of passive investing presents a vulnerability to the system, but there is no doubt it represents a change. By extrapolating the trend in passive investing, Moody’s Investor Service forecasts passively invested assets to exceed those actively invested by the end of 2021.
Passive may exceed 50% market share by 2021
Source: Moody’s Investors Service Calculations for base case forecast dated 2/2/2017 available here: http://www.n3d.eu/_medias/n3d/files/PBC_1057026.pdf
Passive investing is a strategy typically implemented by holding securities in line with their representation in an index, offering a diversified and low-fee portfolio. However, some fear that the mechanical investment rules of passive investing may give rise to distortions in the pricing of individual securities and might reduce diversification while amplifying investors’ trading patterns on the overall market.
Different vulnerabilities may mean different risks
Market watchers tend to look for the signs that in the past signaled a shock was developing into a crisis. Yet, there are some reasons to think that the probability of a repeat of a past crisis or something similar has eased. The changes we have seen should help reduce the vulnerability of the global system to shocks like those of the past.
Of course, risk has not been entirely eliminated from the system. Vulnerabilities have shifted which may make the shocks that pose the greatest risk of a crisis somewhat different than those of the past. Of these, the potential risk posed by a shock from higher interest rates coupled with a stronger U.S. dollar may pose the greatest threat to a vulnerable financial and economic system.