Where Will The Next Global Financial Crisis Begin?

We all know the term "You're only as strong as your weakest link". We also all know that the global financial system is now a very much intertwined and inter-related system. If there is a major global market (let's call them Epicentres) that goes into serious structural decline , then because of the aforementioned nature of the financial system, the risk to your globally diversified portfolio (and mine by the way) is 'Contagion' that spreads on a global basis and then fear based sell off's in multiple global asset markets. Global Financial Crisis Epicentres is of paramount importance if your goal is to protect your wealth in the event it starts to materialise.

In a recent survey of global fund managers, the consensus view was that the world is in the “late-cycle” period of growth in the current economic cycle. We are at the end of a long bull market sustained by central banking stimulus. As a result, major global economies and governments have record debt levels and were it not for the intervention of central banks, the recent recoveries and bull markets might not have materialised.

The Psychology of Boom Bust Investing

In the short to medium term at least, financial markets are driven by Fear & Greed, News & Sentiment. The Coronavirus global stock market sell-off is one of the best examples.

So how do we approach this as investors? Is it all doom and gloom?

Well not necessarily. When a market crashes you are being presented with buying opportunities. The Great Depression of the 1930’s came with a lot of hardships, but it was also a time of innovation and increased numbers of new businesses springing up. When does legendary investor Warren Buffet say the best time to invest is?… At the time of maximum pessimism.

Stock market crashes are an inherent and inescapable part of investing in the stock market…

If you invest in stocks, you need to accept that stocks and entire stock markets go down as well as up.

Not fully accepting this and investing with a fear-based mindset is the wrong way to think and will lead to investment losses. At Boom Bust Invest we take a contrarian approach…

Crashes can be a profitable time to invest!
You need to be able to profit no matter what direction the market goes.

This is what Boom Bust Invest is all about. It will be continually updated in an attempt to alert you ahead of time to the signs and signals of an emerging financial crisis.

A Predictable Crisis

For 35 years, debt has become steadily cheaper. That’s why the world has seen such an extraordinary debt boom. Government debt to GDP, the average mortgage, student debt, credit cards, corporate debt and every other form of debt have all surged. Especially in Britain by the way.

But it hasn’t been smooth sailing. Each time interest rates spiked on their 35-year downtrend, we saw some sort of financial crisis.

In 1987, the US ten-year Treasury yield spiked from 7% to over 10%. Then came the infamous Black Monday, a record stock market rout.
In the 1990s, countries in Asia and South America endured a crisis each time rates rose.
A default of a Thai property developer called Somprasong Land & Development in 1997 led to the biggest one-day drop in the US stock market ever and the IMF rescue of entire nations. A record stock market tumble in 1997 led to Wall Street closing for the day.
In 2000, the tech bubble burst after a series of rate hikes.
In 2008 it was sub-prime borrowers in the US who suffered when rates rose. Out of the blue, sub-prime mortgages and their related ‘debt products’ sold on to investors all over the world unleashed financial and economic chaos comparable to the Great Depression.
In 2012 it was European governments with their sovereign debt crises. We also had the taper tantrum of 2013.

You can see some of these crises pointed out in the charts below.

Each one happened after interest rates rose…

This chart from Bank of America shows the same phenomena going back much further.

Even at today’s ridiculously low interest rates, the phenomenon still plays out. When US interest rates briefly spiked in 2018, they triggered a 10% correction in the US stock market.

Recent central bank interest rate reductions to combat the economic fallout of the Coronavirus are likely to be temporary. Once the Coronavirus subsides, interest rates are likely to resume an upcycle once more.

The American Federal Reserve, the European Central Bank and the Bank of England all have designs on a tightening path for the future, increasing their interest rates. The ECB just ended QE. America’s Federal Reserve was blamed for the sudden drop in stocks we saw in the last few months of 2018. And the Bank of England is warning rates will rise.

Given the proven propensity of a crisis to occur while borrowing costs are rising, when interest rates begin their upcycle, the crash alert flag will be hoisted.

Our financial system is so interconnected, and in surprising ways, that studying cause and effect is difficult to say the least, and the ability of contagion to surprise us and defy logic seems to be the case with each new crisis.

However, some individuals and financial companies did actually forecast the US sub-prime crisis in 2008 and profited handsomely from it. So it’s not beyond question. In this article, we will look at the main pressure points in the global financial system. The name of the game is then to evaluate and monitor the main candidates for their level of severity and potential for triggering a new financial crisis.

Every stock market crash may be different, but their effect on your financial and emotional welfare is real so it’s something you need to keep abreast of as an investor. Despite the apparent doom and gloom, this article might be criticised for, quite on the contrary, its intention is to make you sleep easier at night knowing the truth about what is happening in financial markets and being informed ahead of the game so that you can make your own informed decisions about what to do with your finances and investments.

“Another stock market crash is coming. The only question is, what will trigger it and when.”

However, despite over-priced stock markets, there appears to bet yet more mileage left in the tank before we run out. For the most part, this is down to the continued globally co-ordinated intervention of central banks and fiscal stimulus by governments the world over, who live in fear of deflation and being voted out of power.

The problem with this unprecedented global credit expansion is that it just ‘kicks the can down the road’… risking a much bigger crash further down the line.

Some financial cycle analysts see this all coming to a head sometime between the mid-2020s and 2030. This is guesswork of course but that seems about right considering ALL analysts, economists, and fund managers, think we are in the latter stages of the current bull market, and the accumulation of all the risks identified in this article, will eventually be too much for the central banks and governments to contain.

This cannot go on forever… something has got to give…

Below are the main candidates that could lead to systemic problems in global financial system. I have ordered them in, what I think may be importance and potential to trigger something bigger. I will be monitoring each and updating as things unfold so check back on this blog article for the lowdown.

(If related to a particular Geolocation I have called it an ‘epicentre’)

Epicentre: Italy

Italy is sitting on top of a mountain of debt and have underlying structural faults in its banking system.

You can find a more detailed analysis of the Italian contagion risk to the global financial system here:-

LINK (new tab): Financial Crash-watch: Italy & The Eurozone

Below are some of the main points:-

Italy has entered a “perma-recession” with no obvious way out.
European Union rules prevent government deficit spending that might grow the economy out of its troubles.
Italy’s debt-to-GDP load has reached heights not seen since World War II.
The scale of such a collapse would be magnitudes greater than the Greek debt crisis of 2015, with contagion large enough to affect the entire global financial system.

Epicentre: Europe & Brexit

Other EU members are likely to face their own significant populist backlashes. Potential future departures for Italy, Greece, Poland, and other Visigrad EU members? There is still the possibility of a breakup of the EU.

Epicentre: China

China is not a safe haven for capital, and nor will it become one. Its enormous debt overhang and need for endless money printing programmes to give the populous, something, anything to do, not to mention its status as a dictatorial state, doesn’t inspire the confidence of investors in a crisis. In fact, China may well end up being ground zero for the next global financial crisis due to its enormous debt burdens.

I sometimes wonder if the same culture of punishing and hiding ‘failure’ (including economic failure) by the Communist ruling party, is the same or similar to Japan in the 90's, leading to Japan's eventual mega-crash when the over-valuation of assets, cooked accounting books, and resultant losses could no longer be hidden.

China is the most leveraged country in the world and this is a big risk now as they will find it hard to control that leverage. Even if they don't cause the bust, they will find it hard to control when the bust gets going.

Chinese Property Market Contagion

The Chinese property market is collapsing. This has a fair chance of causing some level of systemic contagion as global banks and institutions hold these bonds. The Chinese property market is BIG! It’s about $60 TRILLION. Twice the size of the US property market. 29% of China’s GDP.

Evergrand is the biggest developer in the country and it recently cobbled together its most recent bond interest payment but how long will be able to continue paying these if nobody is buying their developments? The same goes for all the other big developers in China who are in trouble.

UPDATE SEP 2023: -

China’s economy appears to be entering a severe crisis. Youth unemployment, the destruction of vast quantities of savings invested in the property sector, a crash in local government financing and a dangerous demographic gender imbalance are the perfect recipe for political upheaval.

If this is a correct interpretation of the hazy state-controlled economic data emerging from China’s economy, it presents President Xi Jinping with a problem that also includes the prospect, strategic scenario of invading Taiwan. Any build of of maritime or land resources and troops pointing to a potential invasion could spark a global stock market sell-off if diplomatic efforts to prevent such an outcome were not successful. The invasion scenario might not be on the cards right now but it something that should be tracked as the hint of this becoming a reality would mean your Pension (a.k.a globally diversified stock fund) would sell-off.

In the mean time, A likely capitulation of the Chinese government and central bank, resorting to ramp up the money printing machines yet again, would mean a likely rise in both Chinese and Global stock markets.

Epicentre: Emerging markets

Over-indebted emerging markets are falling like dominoes, and seem to be overly dependent on what the US Federal Reserve is up to.

Turkey & Argentina

For now, the collapses are in slow motion. They began with Argentina, which sought another International Monetary Fund (IMF) bailout. In mid-2018, Turkey came next. The Turkish lira was down about 70% in one year alone.

Approximately 40% of Turkey’s debt is denominated in foreign currencies, which means that Turkey’s debt service has just got a lot more expensive as the lira has depreciated against the US dollar and other harder currencies. Its debt is rated as ‘Junk’ status.

Famed City Investment Guru Russel Napier has this to say on Turkey and Emerging Markets:-

“Turkey has the potential to be the largest EM default of all time, should it resort to capital controls, but it could also be the largest bankruptcy of all time given the difficulty of its creditors in recovering any assets. History is littered with numerous examples of those who could pay but have chosen not to.

One wonders why investors expect President Erdogan, a man who has referred to them as like the loan sharks who enslaved the Ottoman Empire, to choose to repay the foreigner and accept the crushing Socio-political cost on the local population of doing so?

This is the new normal. In a world where ten years of extreme monetary policy has failed to inflate away debts, it will become increasingly common to repudiate those debts. Those under the most pressure will be those with the highest levels of foreign currency debt where inflation can play no role in reducing increasingly crushing debt burdens

– almost exclusively emerging markets.”

Anyone Else?

But as Ambrose Evans-Pritchard wrote in the Telegraph at the time… “Turkey is the first big victim of Fed tightening, but it won’t be the last”

Attention immediately turned to Spain, one of Turkey’s biggest lenders, Poland thanks to its external debts, and Italy, because of its precarious banking sector and government financing.

What’s the connection between emerging markets and rising interest rates? Gary Shilling, an economist who predicted the 2008 crisis, says, “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.”

These countries and their companies borrowed money. Often overseas, in foreign currencies. When their home currency tumbles, it becomes harder to repay that debt. The Turkish Lira has dropped against the dollar and other currencies. Erdogan then assumed control of the Turkish central bank which is probably the worst possible thing for turkey. In the last several years the Lira has lost about half its value. Gold and foreign currencies are now being bought by citizens and there have been runs on the banks. Turkish tourism is devastated and this is a big part of turkeys economy.

Inflation has soared to over 11%.

Contagion Risk

European banks, which clearly have exposure to Turkey through what now seems to look like highly imprudent loans, will also be impacted

Historical Precedent

If this sounds obscure, look more closely. In 1997, a different set of countries faced the same problems. The subsequent crisis triggered the biggest ever drop in the American Dow Jones Industrial Average index. It forced trading to be suspended for the day. The FTSE 100 posted two successive daily tumbles of 10%. Entire countries went broke and had to be rescued.

Yes, emerging markets struggling to repay their debts is nothing new. But the chief economist of the Bank for International Settlements, Claudio Borio, pointed out that US-dollar-lending to non-banks in emerging economies “has actually more than doubled since the Great Financial Crisis to some $3.7 trillion”.

The size of the problem is massive.

And in case you’re wondering why you should care, emerging market crises and contagion are very much your problem if you hold shares, as 1997 showed.

Epicentre (Risk): Global Debt LevelS

As a percentage of global GDP, the world is now 12% DEEPER in debt that it was at the height of the last crisis in 2009.
Total debts stand at $233 trillion, according to the latest figures from the Institute of International Finance. A record high.

Surely there is a risk that this active debt volcano will eventually explode and cause a financial cataclysm?

On the 10th anniversary of the Lehman Brothers bankruptcy, every journalist and commentator gave their take on the financial crisis and what’s changed since. Plenty agreed that nothing has been fixed and we face the same threats today as we did back then. Banks are bigger and more interconnected than ever.

The total amount of debt in the global economy has never been higher, reaching 318% of GDP in 2018. Imagine what this figure is now!

Euro Debt

Of Europe’s famously over-indebted nations which triggered the 2012 European sovereign debt crisis, only Ireland has made progress in cutting its debt-to-GDP ratio. Even after its bailouts and defaults, Greece’s debt to GDP is higher than ever…

PIIGS debt to GDP

Source: Google Finance

The Zombie Apocalypse

The amount of “zombie” companies is still rising according to the Bank of International Settlements, the only major organisation which foresaw the 2008 financial crisis.

The share of ‘zombie’ stock market-listed companies in developed countries was above 12% in 2015. That means 12% of our companies can’t pay their debt costs out of profits.

They’re borrowing to repay. And that’s BEFORE interest rates rise. The share of zombie firms has quadrupled since 1995.

Usually, financial crises clear the skeletons out of the closet. But it seems the dead bodies hidden on corporate and government balance sheets are coming alive – zombies indeed.

Deutsche Bank losses for the first half of 2020 hit 120 million euro. Financial Stability Board has declared Deutsche Bank too big to fail… if it fails the entire global monetary system could fail so would need to be bailed out by the German state

Epicentre (Risk): Overpriced Markets are Susceptible to a Crash

On a Shiller Cape basis (with a current p/e of over 30 times), the S&P 500 stock index is now at its second-highest level in history, surpassed only by the giddiest days of the first dotcom boom, and higher than the index was before the Great Crash of 1929. On a Shiller Cape basis, US stocks are arguably overvalued by over 80% relative to their long run average.

The graph shows the main US Stock Market index through the lens of the Shiller PE ratio for the S&P 500 with the Price-earnings ratio based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10.

Nevertheless, quantitative easing (QE) and zero interest rate policy (Zirp) have wreaked some incredible “upwards damage” on stock markets and we may yet see plenty of further gains before the forces of gravity reassert themselves.

Epicentre (Risk): Economic Cycles. We are Overdue a Crash

Global growth is slowing and historically, after more than 10 years of growth, chances are we’re probably overdue a crisis. Following on from the sub-prime mortgage defaults in the US, the UK caught the American cold…

The 2007 Northern Rock disaster, the first run on a UK bank in 150 years, British shares and property both logged their worst-ever year in 2008. House prices dropped 16.2% and stocks shed 31% of their value.
The Royal Bank of Scotland went into state ownership, bailed out with taxpayer money amounting to £617 per man, woman and child in the UK, after reporting the largest annual loss in UK corporate history, $24.1 billion down the drain.

The lesson to learn from the history of financial crises is that they happen, not just often, but regularly. Just like the economy, financial markets move in cycles.

If a crisis occurs every seven years on average, then you’ve got to start paying attention after the sixth.

There are many such theories with different versions of how long the cycles are and what causes them. But they all agree on one thing.

"The longest bull market in history is overdue a crash."

The US recently surpassed the previous record for how long the market has gone up without a correction of 20% or more. Stocks in the US have never gone up so steadily for so long before.

It’s much the same over in the economy. The US has had the second-longest run of steady economic growth ever. Many economists such as Steve Keen and Nouriel Roubini are predicting a US recession in 2020.

The UK has had an extraordinary run since the last market low in March 2009, closing in on the FTSE’s all-time record bull run. That alone should have you thinking about how to prepare.

Global Stability & Risks

The IMF’s Global stability report highlights the main risks to the global financial system. For our UK readers the UK Government ONS UK Economy report gives us our summary or the UK...

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