Where Will The Next Crisis Come From?

Since we're the kind of group that is always on the lookout for signs of the next big market downturn, today's edition of Barry Ritholtz's "The Big Picture" contains an article from Schwab that struck me as quite relevant -- 7 metrics to monitor that could signal the next crisis.  There is a terrific graphic to go with each talking point which, as usual, did not translate to this blog so, for the entire Big Picture, please click on the link below.  You might also take some pleasure in this graphic showing how badly bitcoin has crashed this past month.  I'm sure most of us are very much on the fence about bitcoin and this particular illustration posits a very good reason why we should continue to be.  Hope everyone's having a great weekend.


Get Ready for Most Cryptocurrencies to Hit Zero, Goldman Says

Sat 9-1-18 BigPic: 10 Weekend Reads - The Big Picture


Sat 9-1-18 BigPic: Where Will The Next Crisis Come From? | Charles Schwab

Where Will The Next Crisis Come From?

By JEFFREY KLEINTOP

AUGUST 20, 2018

Key Points

·  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

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. 

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.

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. 

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.

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. 

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: 

1.   High debt levels could magnify a shock from higher interest rates.

2.   Political fragmentation may impair an effective response to a shock.