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The next economic downturn

The Next Global Economic Downturn

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The date is 2020. This has been on the lips of economic analysts for the better part of 2018. Ever since the collapse of Lehman Brothers, economists have managed to converge on the exact source of the financial crises. And while central banks have managed to curtail the rippling effect with massive bailouts and stimulus packages, there still remains the possibility of a relapse.

The reasons behind these gloomy forecasts seem straightforward enough. From America’s large deficits and cheap loans, to China’s loose spending and the presence of automated trading platforms, it is only a matter of time before the next financial crisis.

What happened to the Brothers?

It is a very short story, one told along the lines of a poorly regulated sub-prime market. Put simply, Lehman Brotehrs went bust, bringing a host of jobs and a huge chunk of the global economy with it. For the longer, more nuanced version, the financial sector had been under serious stress in the years leading up to the financial crisis and Lehman’s collapse. Northern Rock had suffered a bank run in the UK in 2007 while another American bank, Bear Stearns, had to be rescued by the Feds in March of 2008.

Aside these two banks, bankers in America were engaged in high-risk deals disguised as quick-profit ventures. For a couple of years or more banks were buying mortgages of poor Americans in large amounts. These poor mortgages were then combined with mortgages of better quality and sold to investors as risk-free mortgage-backed assets. In 2006, however, when the US started increasing interest rates, many homeowners were unable to pay their premiums. House prices fell as households defaulted on their payments. This meant those banks who held these assets held potentially bad debt. But because these mortgages were hidden in securities, lending banks weren’t sure who carried them. To play safe, banks charged high rates whenever they gave credit to fellow banks. This lack of trust in each bank’s solvency led to a credit crunch and the blooming of the 2008 financial crisis.

For some reason the Fed refused to bail Lehman Brothers. Unable to rollover its borrowings, and facing high costs in the money market, Lehman Brothers suffered dire liquidity challenges. There was, and continue to be, an ideological takeover in western governments; bankers and politicians all favoured less regulation to better regulation. From America to Europe and Japan, Central Banks and politicians believed the market would rectify itself whatever happened.

When the invisible hand failed to do its job, the financial crisis exposed how the world’s financial systems were integrated. Lehman Brothers had liability worth some $700 billion but not enough cash. Banks were exposed to each other’s risky ventures not just on the local scene, but on a global level. Andy Haldane, the Chjief Economist at the Bank of England said in 2010 that the financial crisis cost the world between $60 and $200 trillion in foregone economic growth.

The tell-tale signs of a meltdown

Economists and analysts have pointed out clear signs of a looming disaster these past years. Pointing to Lehman Brother’s leverage, it became clear large over leveraged banks posed serious risks to the financial architecture. For the market to stay safe, the Volcker Rule was passed in 2010 by President Barack Obama. At its heart, the Volcker Rule barred investment banks from betting on movement in the financial market using their own money. They were to stick to trading on behalf of their clients and little besides.

Deregulated Over-sized Banks

But things are changing, or they have stayed the same. There are still very large banks in America especially. JP Morgan, Citigroup, Goldman Sachs, and seven others, own more than 50% of all the assets of the top 100 commercial banks. JP Morgan especially has doubled its size since the crisis that took down Lehman Brothers, the fourth largest bank in America at the time of the financial crisis. Bank of America has also grown some 50% since then.

Big banks are not agents of disaster by themselves. In fact, the new regulations since the financial crisis should make them better at managing investor funds. However, large banks have serious implications for the entire banking sector because of the size of their portfolio; big banks have large assets, but big banks also fall even harder.

Also, the deregulation bug continues to grow bigger. Donald Trump is heeding to his Wall Street advisors and pursuing further deregulation of high finance. The Fed has decided to water down the Volcker Rule which had been established to ensure the events of 2008 did not repeat themselves. Without a guiding hand, banks are being tempted to indulge in riskier bets that could have dangerous repercussions for the world.

Also, congress is removing portions of the Dodd-Frank Act which offered massive oversight and stringent stress tests for mid-sized banks. These tests were put in place in 2010 after the crisis to ensure banks were able to withstand a financial crisis. The Dodd-Frank Act was built to internalise the risky behaviours of big banks in a regulatory framework that would oversee their activities. According to the act, any bank with assets of $50 billion fell under additional strict Federal regulations. The repeal or tinkering, whichever way you see it, sees the cap raised to $250 billion. Despite receiving bi-partisan support, the result of the roll-back could be good or bad depending on how it affects the risk profile of the large swath of small banks that would be affected.

Is the Economy Overheating or Not?

Unemployment levels in America are stable at 3.7%, a 49-year low as at October 2018. Wages have grown 3.4% in annualised terms over the same period, while average hourly rates increased by some 2.8%. But what if unemployment rate fell to below 3% by 2020, with wage growth rising by some 3.5%? At current rates, this looks like it will happen and economists are worried about its effect on igniting a financial crisis.

With the natural unemployment rate estimated at 4.5%, further decline in the unemployment rate could cause dire consequences for the American economy. The economy will outgrow its capacity to satisfy demand, leading to higher levels of inflation and slower growth. “So the economy really needs to slow to avoid a dangerous overheating,” Goldman’s chief economist, Jan Hatzius, said in November 2018.

With cheap money due to low interest rates and a stimulus package that is putting excess cash into the economy, the Fed might have to respond by raising its Reserve Fund Rate to ward off any chance of a financial crisis setting in. But Trump doesn’t like that.

He has continuously voiced his displeasure at Jerome Powell, Chairman of the Federal Reserve Bank, for increasing interest rates to stave off inflation. The Fed increased interest rates three times in 2018, and analysts are bracing for more increases in 2019, due, in part, to the excess liquidity and cheap loans flooding the economy.

Protectionism and Political Wars

The US-China trade war looks like it has cooled off a bit. Even if both countries eventually call off hostilities, the seeds of discontent have been sowed. Given that politics has been read into the banning of Huawei in some 5G installations in US and its allied countries, the stage is dangerously set for massive retaliation from China. The nature that could take is still not certain. However, the immediate effect is a radical change in the supply chain that could affect production levels or make products more expensive.

And then there is Iran, who has been on the receiving end of some very blunt attacks from current president, Donald Trump. Escalation in tensions could lead to sky-rocketing oil prices that would have dire consequences for the global economy. In the USA where the talk of overheating is ripe, increasing interest rates and high oil prices could lead to the US economy slowing down, triggering a further slowdown in the global economy.

The Great Liquidity Crisis

According to JP Morgan’s Marko Kolanovic, the next crisis will be exacerbated by liquidity crisis due to passive investment. “The shift from active to passive asset management, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns,” Bloomberg reported. According to the report, the switch to exchange-traded funds and quantitative-based trading strategies has reduced the pool of funds that would normally be available to backstop a market disruption during a financial crisis.

The disruption will result in the S&P index shaving off 20% of its value. Also, stocks in emerging economies will slide some 48% with a 2.9% spread on government debt in those nations. All of these could happen soon, and fast, due to the high level of tech involved in the financial market.

Algorithm-dominated Market

Flash sales could be the trigger that causes the next financial crisis. Flash sales “…are very rapid, sharp declines in asset values with sharp increases in market volatility,” Kolanovic described late 2018. They occur after very prolonged periods of calm trading and happen very quickly. These incidents are exacerbated by the rise in automated trading platforms that are programmed to sell-off assets at the slightest trigger.

Close to 90% of daily trading and two-thirds of global assets under management are traded using automated-trading platforms. Most investors, thus, are selling “…on certain signals and not necessarily on fundamental developments, such as increases in the volatility index (VIX), or a change in the bond-equity correlation, or simple price action. Meaning if the market slumps 2%, they need to sell. That is a lot of people trading on the value of information rather than actual market performance.

No Room to Operate

Central banks are able to make meaningful impacts during a financial crisis when they have room to operate. The interest rates must already be high enough for any reduction to have any effect on the global economy. Given the current 2.5% in America, Economists fear there is room for only a little push.

In addition to this, the consensus that followed the decisions major central banks took doesn’t seem like it exists now. Countries are becoming insular to bloc agreements. In the EU especially, anti-immigrant, far right politicians are taking hold of policy institutions. Populist measures generally jeopardize the fabric that binds a union, and countries like Italy seem to be going in that direction. The effect is that the EU would find it difficult pursuing EU-wide policy measures to arrest some of these dangerous antecedents.

A Grand Warning

The extent to which the world will suffer another financial crisis depends on the preparedness of central banks and financial markets. The messages being sent by market observers and economists are meant to draw the attention of financial players and their regulators. An early strategy that minimizes risk-playing among bankers would help minimize systemic risks in the economy. Also, cheap loans might be good for the global economy but stagflation could have its own dire consequences if central banks do not take the needed steps to keep the global economy in balance. 2020 is a date the world must miss.

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