Financial crises, whether they be global, regional, or local, are a recurring phenomenon. We do learn from some of these crises to develop new financial market regulatory reforms to minimize repeat occurrences.
Thoughtful commentators can and do advise on impending financial market crises. For examples, the collapse of the high-tech equity stock market bubble in January of 2001 and the collapse of housing price bubbles in countries like the United States, Spain, and Ireland during the late-2000’s were each predicted about two years in advance by several financial market observers, including myself.
We are less competent in predicting the “black swans” (highly improbable events) that trigger major financial crises. Consider here the unexpected 30% collapse of global equity prices in a single day in October 1987, the development of the regional Asian financial crisis in the late 1990’s, and Russia’s unexpected default on its sovereign debt obligations in 1998.
History does tell us that several mutually re-enforcing events and decisions, rather than a single catalyst, tend to contribute to major financial market crises. However, excess debt is usually part of the problem.
This paper develops the view that the next financial crisis will be triggered by a global debt crisis. The paper reviews developments since the collapse of Lehman Brothers in the fall of 2008 with focus on (i) the evolution since 2007 of country sovereign debt obligations, (ii) the degree of preparation of large US and European banks to cope with another financial crisis, (iii) the implications of changes in the composition of borrowers profiles in the international non-financial corporate debt market, (iv) changes in the composition of global household debt, (v) some thoughts on the timing, possible causes, and potential severity of the next global financial crisis and recession, and (vi) some thoughts on how well-prepared are major economies or regions to address the consequences of another financial crisis and/or recession.
The conclusion is that excessive overall levels of global debt, the changing composition of debt offerings in the international debt markets, the lingering possibility of aggressive US central bank interest rate policy and likely refinancing challenges for non-investment grade corporate borrowers are most likely to propel us into the next global financial crisis and recession. Trade wars could also be a contributing factor as well as destabilization of the geo-political situation in the Middle East. Brexit should not create a regional or global financial crisis. Emerging countries could suffer most from the next financial crisis and recession. With current public debt levels, advanced country policy makers are not well-positioned to provide adequate fiscal or monetary stimulus in the event of another global financial crisis and recession. Longer-term, increasing inequality of income distribution and wealth could challenge social acceptability of the capitalistic model of wealth creation and sharing.
Sovereign Debt Developments
Several respected economists argue that a public debt to GDP ratio is unsustainable at levels above 80%. This argument has two empirical foundations. First, ratios above this level typically result in bond rating downgrades and higher borrowing interest costs. Second, interest expense becomes too large as a percentage of total government expenditures to sustain. It should be noted here that most of the research leading to these conclusions are based on the experience of emerging countries.
Since the collapse of Lehman Brothers in October of 2008, sovereign country borrowings in BIS countries have more than doubled, reaching $64 trillion at the end of 2018.5 More alarming is the country composition of this debt. In 2007, only two significant countries had ratios of public debt to GDP in excess of 100%: Japan at 175% and Greece at 103%. Current IMF forecasts for 2019 show a growing number of countries with public debt in excess of 100% including Japan (237%), Greece (183%), Italy (132%), Portugal (121%), Singapore (108%), USA (106%), and Belgium (101%). On the cusp are Spain (97%) France (96%), Brazil (90%) and the UK (86%). Collectively, advanced economies have an IMF forecast of public debt to GDP of 103% for 2019.6
We should not worry so much about Japan and Singapore. Their public debt is in national currency, almost exclusively held by domestic investors, and relatively immune from credit downgrading by foreign investors and international bond rating agencies.
The US evolution of public debt is most concerning. Currently, the interest debt service ratio to GDP is around 10% in the US, like the situation in Latin America, but well above the ratios in other countries and regions of the world. Current US government budget projections indicate that US debt service obligations could reach in excess of 20% of the US federal budget by 2028 if there are no tax increases or reduction of planned social benefits over the next 10 years. (Money and Markets, November 13, 2018).
40% of US public debt is owned by foreign investors today with China being, by far, the most important creditor. In recent years, China has indicated that it views US public debt as risky debt fearing that the US will ultimately resort to domestic inflation to reduce the burden of its public debt obligations. China is responding by reducing the level of its US dollar reserves in favour of Japanese yen and South Korean won, reducing maturities of its US reserve holdings, and financing Chinese direct corporate investments abroad.
The Rhodium Group research firm reported in May 2019 that the level of Chinese direct investments in the US has declined on an annual basis from $46 billion in 2016 to $24 billion in 2018. Contributing factors included Beijing’s urging of Chinese companies to reduce levels of debt-financed investments and new US congressional laws that make it harder for Chinese companies to invest in US companies or to buy cutting-edge technology developed in the US.
These developments are being noticed by prominent US hedge fund managers. Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, warned in September 2018 (Bloomberg interview) that there is a significant risk that the US is on path to lose its status as the global reserve currency. Larry Fink, CEO of BlackRock, agrees with Dalio. Commenting during a November 2018 Bloomberg New Economy Forum in Singapore, he had this to say: “We are going to have more and more debt because of the (fiscal) deficits, and because of the deficits, the investors are going to demand a bigger (risk) premium. … Generally, when you fight with your banker (through trade wars), it’s not a good outcome”.
Mortgage Market Developments
Unsustainable levels of household debt associated with home mortgages and mispricing of these obligations in the US and later in overheated European markets contributed heavily to the last global financial crisis and great recession. In the US, defaults on home mortgage loans peaked at more than 11% of all mortgage loans in 2010.1 Since then, US banks have reduced their exposures to sub-prime household mortgages, being replaced as creditors by nonbank lenders, particularly private equity and hedge fund investors. Mortgage markets, while still fragile, are not likely to be at the center of the next global financial crisis.
Western Banks are Safer but Less Profitable and Less Attractive to Investors Relative to 2007
During the recent financial crisis, Western banks have downsized their balance sheets, reduced exposure to risky balance sheet assets, and de-leveraged. For the most part, these developments were mandated by policy makers and regulators worldwide to strengthen the global banking system to better withstand future financial shocks.
The Tier 1 capital ratio (essentially core bank equity in relation to risk-adjusted assets) has increased from less than 4% for US and European banks in 2007 to more than 15% in 2017.1 “Return on equity for banks in advanced countries has fallen by more than half since the crisis. The pressure has been greatest for European banks. Their average ROE over the past 5 years stood at 4.4% compared with 7.9% for US banks”1
Significant fines, penalties, and settlements for the 6 largest US banks and 5 largest European banks have impacted on bank ROE numbers since 2009. For the most part, these settlements (estimated at $243 billion in an April 2018 study by Keefe, Bruyette, and Woods) have been associated with misleading investors about the underlying quality of the mortgage loans they packaged into bond instruments during the US housing bubble.
While US bank equity share prices have recovered more fully than those for European banks since the lows of 2009, investor confidence is not strong today for big banks. Looking at 2017 average price to book ratios (equity share price divided by book value of equity per share) for the 10 largest US and 10 largest European banks (weighted, in each sample by bank balance sheet asset size), my research shows a ratio of 1.29 for US banks and 0.69 for European banks. To put these numbers in perspective, US bank equity shares had a price to book ratio above 2.0 in 2007 and US equities, on average, were trading at a ratio above 3.0 at the end of 2017. (Price to book ratios from Reuters and Star Capital).
McKinsey Global Institute, with a larger sample of 1,000 banks in 70 countries, each with total assets exceeding $ 2 billion provides similar findings. “… in every year since 2008, most advanced economy banks have had average (equity) price to book ratios of less than one (including 75% of EU banks, 62% of Japanese banks and 86% of UK banks.) Even with dramatic operational cost cuts and enhanced risk management and compliance staff, McKinsey concludes that “… banking could become a commoditized, low margin business unless the industry revitalizes revenue growth.”1 While banks may not be at the center of the next financial crisis, investors are not currently very optimistic regarding the ability of large global banks to create significant future shareholder value.
Evolution of Non-Financial Corporate Debt Obligations
In parallel with the evolution of sovereign debt obligations since 2007, debt obligations of non-financial borrowers increased to $77 trillion in 2018, roughly matching the increase in government debt to $64 trillion over the same period.7
During the last 10 years, the composition of non-financial corporate debt has changed dramatically with Chinese corporate debt increasing by 550% and emerging market corporate debt (including China) increasing by 256% in comparison with a 40% increase in advanced economies and a 24% increase in the US. In early 2018, Chinese non-financial corporate debt represents 24% of global non-financial corporate debt with other emerging countries contributing 29% of the total. This compares to ratios of 3% for China and 12% for other emerging economies in 2007.7
McKinsey Global Institute notes that non-financial corporate bonds outstanding have more than doubled the last decade and comments as follows. “As the (international) corporate bond market has grown, credit quality has declined. There has been notable growth in non-investment grade “junk” bonds. Even investment-grade quality has deteriorated. Of corporate bonds outstanding in the United States, 40% have BBB ratings, one notch above junk status. We calculate that one quarter of corporate issuers in emerging markets are at risk of default today – and that share could rise to 40% if interest rates rise by 200 basis points. Over the next five years, a record amount of corporate bonds will come due, and annual refinancing needs will hit $1.6 to $2.1 trillion. Given that interest rates are rising, and some borrowers already have shaky finances, it is reasonable to expect more defaults in the years ahead.”1
Evolution of Household Debt
Over the last decade, total household debt in BIS reporting countries has increased by 25% to more than $46 trillion. While growing from relatively small bases, household debt in China has grown by 772% over time period with household debt in other emerging countries growing by 93%. Compared to the third quarter of 2007, household debt of all emerging countries has grown from 9% to 25% of global household debt in all reporting BIS countries. US household debt has grown by a more modest 5% while the growth in other advanced countries has been 1%.7
Although Greece exited the last of its three EU bailout programs in August 2018, its public debt problem is far from being resolved. To protect EU banks, Greece’s debt repayment schedule has been restructured through lower interest rates and extension of some maturities out to 2060. In compliance with its last bailout, Greece is now running a fiscal surplus and is growing GDP again, although with a projected unemployment rate of 20% for 2018. Bloomberg (The Blomberg View, Bloomberg Businessweek, August,2018) argues that EU projections for future Greek public debt reduction are unrealistic and unbearable for the country. Greece must run an average budget surplus of 3.4% of GDP (excluding interest payments for a decade and then 2.2% until 2060 to get its public debt to GDP ratio down to 100% by that year. This scenario implies a sustained level of austerity over several decades that no European country has experienced to date. Bloomberg estimates that with more realistic assumptions, Greece would need additional future public or private bailouts to support a ratio of public debt to GDP closer to 300% by 2060. And, other commentators note that the EU may also have to bail out Italy in the near term.
More than two years have passed since the UK referendum on Brexit. The UK has a new Prime Minister, Boris Johnson, who faces an October deadline to negotiate a “soft” Brexit. Since taking office, Johnson has indicated that he would prefer a better EU exit deal but is quite prepared to have the UK leave the EU in October without a deal. He has also indicated that he will not call for a general election in 2019. Brexit will not trigger a global or European recession. The effects will fall largely on the UK that may in turn try to create a favourable bilateral trade agreement with the US. Currently, 15% of
UK trade is with the US compared to 11% with the EU. Since mid-2016, pound sterling has declined in value by 14% against the Euro and the US dollar. Currency markets look to be forecasting a “hard” Brexit outcome.
Trump’s Trade Wars
Economists generally agree that the Trump trade wars have led to reductions in GDP growth both in the United States and in China. Some fear that further escalation of the US-China trade war could be the primary cause of the next global recession. I do not think that China or the US want to see further escalation. Donald Trump wants to bring manufacturing jobs back to the US, increase exports of US agricultural products, maintain US technology leadership, and reduce the US trade deficit with China. His Chinese negotiating counterpart, Xi Jinping, is willing to decrease China’s dependence on the export economy while stimulating an increase in domestic consumption as a % of GDP, and perhaps most importantly positioning China as the global technology leader at the expense of the US. Trade talks will continue between the two countries but China is not likely to bend on Trump’s demands related to the transfer and use of intellectual capital flowing from the US to China. The most likely scenario is that China will continue to negotiate but defer settlement hoping that Trump will not run for or be elected to a second term in 2020.
Pockets of Concern Within Emerging Market Countries
Several emerging market countries are already experiencing currency devaluations associated with deteriorating trade imbalances. Argentina, Brazil, Chile, Cyprus, Indonesia, Pakistan, Turkey, and Ukraine fall into this category. These are hot spots but not ones that should create a global crisis or recession.
US Equity Prices
In a global financial market with low interest rates and volatile commodity and real estate prices, institutional investors and global fund managers have shown preference for US equities which has created a 10 year “bull” market for US equity shares, the second longest in US history. During 2019, US equity share price indexes have reached all-time highs. While US equity prices typically trade at a premium relative to equity shares traded in other global equity markets, these prices are very high today with average price to book ratios above 3.0 in comparison with Western European price to book ratios more in the range of 1.5 to 1.7, CEE ratios typically close to 1.0, and Russian and Ukraine equity shares selling at a deep discount to book value. In relative terms, US equity prices are trading today at prices above those of 1929 and 2006, but well below the relative prices that we saw in the US during 2000. Profit forecasts for US companies are declining but still healthy. At some point this pricing “bubble” will burst reducing consumer wealth and buying power. But, it will not be easy to predict the timing of this development.
Predictions Related to the Next Financial Crisis and Global Recession
The National Association for Business Economics released results of a poll of 53 US business forecasters on Monday, October 12, 2018. Of those surveyed, about 10% see the next US recession beginning in 2019, 56% say 2020, and 33% said 2021 or later. More than 50% of respondents cited trade policy as the greatest risk to the current business expansion.
Professor Nouriel Roubini (Stern School of Business, New York University) was one of a few economists who made an early prediction of the US housing bubble crash of 2007-2008. In 2005, he warned that home prices were riding a speculative wave that would soon sink the economy. In 2006 he foresaw “… homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unravelling worldwide and the global financial system shuddering to a halt” (New York Times quote).
In a September 2018 opinion piece published in the Financial Times, Roubini and Rosa predicted that “…by 2020 the conditions will be ripe for a financial crisis, followed by a global recession”. Among other contributing factors, Roubini cited lack of continued U.S. fiscal support after 2020, rising global inflation and interest rate hikes, the Trump trade disputes, over capacity and excessive financial leverage in China, excessive debt levels in many emerging markets and some advanced economies, over-priced US and global equity prices, limited space for fiscal stimulus due to massive public debt levels, limited space for additional monetary stimulus due to bloated central bank balance sheets, and intolerance to future financial sector bailouts in countries with resurgent populist movements, and near-insolvent governments. They anticipated a significant downward re-pricing of risky financial assets in 2019. 2
What Nouriel does not mention is the eroding health of US consumers to survive another severe economic recession. McKinsey Global Institute notes that “In the United States, 40 percent of adults surveyed by the Federal Reserve System said they would struggle to cover an unexpected expense of $400. One-quarter of nonretired adults have no pension or retirement savings.”1 While US mortgage debt has not increased significantly since 2007, US student loans have risen to $1.5 trillion and auto loans have risen to $1.4 trillion over the last decade. (New York Fed Consumer Credit Panel database).
In September 2018 JP Morgan Chase, the biggest bank in the US, also predicted 2020 as the beginning of the next U.S. and global crisis and recession. The JP Morgan model predicted a 20% decline in US stock prices, with interest rates on corporate debt rising by 1.15%. Their model predicted a bleaker picture for emerging countries with energy prices and base metal prices declining by 35% and 29% respectively, a 2.8% increase in the yields on emerging country debt, a 48% drop in emerging market equities, and a 14.4% decline in emerging market currencies relative to the US dollar.3
Roubini and Rosa concluded their Financial Times opinion piece with the following statement: “Unlike in 2008, when governments had the policy tools needed to prevent a free fall, the policy makers who must confront the next downturn will have their hands tied while overall debt levels are higher than during the previous crisis. When it comes, the next crisis and recession could be even more severe and prolonged than the last.”2
Predicting the Timing of Recessions
Of the 469 country recessions since 1988, the International Monetary Fund economists predicted only four of them by the spring of the preceding year. In another study of 153 recessions in 63 countries from 1992 to 2014, only five recessions were predicted by a consensus of private-sector economists in April of the year preceding. It is not easy to predict the timing of recessions even 9 months ahead.4 In context, I am reminded of an old Arab proverb that states: “He who predicts the future lies”.
Interest Rate Policy Could Extend the US Economic Expansion and Bull Equity Market
The US Federal Reserve Bank raised interest rates by 25 basis points in September of 2018 to “stem possible domestic inflation”. Another interest rate hike was announced in mid-December along with a statement that the US central bank was planning another three interest rate hikes for 2019. Financial market reactions were swift and devastating with all three major US equity indexes decreasing in price by at least 15% and with bond prices also falling dramatically.
Refocusing concern away from inflation to recession, the US. Federal Reserve Bank back tracked on additional interest rate hikes in early 2019 and by mid-2019 was sending signals of possible interest rate reductions during the second half of 2019. Financial markets reacted by restoring and then enhancing November 2018 equity and bond prices.
With 2020 being a US election year, Donald Trump will encourage US policy makers to do whatever is possible and needed to prevent a recession and sharp decline of equity prices during 2020.
While I see a global debt crisis rearing its head when interest rates begin to rise again, the US Federal Reserve Bank’s inclination to move back to more “quantitative easing” could delay the crisis . I agree with Roubini that, if this happens, global policy makers will have limited monetary and fiscal policy flexibility to deal with a deep financial crisis and global recession. In the context of managing my personal investment portfolio, I am moving closer to safer harbours while not yet berthed in a safe harbour.
More from Roubini
In an interview with Bloomberg on July 2, 2019, Nouriel Roubini said that “the US disputes with China and Iran will divide the world and spark a global recession in 2020. The consequences of this trade war and tech war and cold war (are) the beginning of de-globalization … and the decoupling of the global economy. We’ll have to redo the global tech supply chain. And eventually by next year, if this escalates, it will be a global recession.”
“My base case is … the trade and tech war between the US and China is going to get worse: Manufacturing is already in a recession globally: It’s affecting services … The tech sector is in a slowdown.”
Roubini also expressed concerns about what proponents of the “modern monetary theory” are proposing to fund additional government spending on social initiatives through printing money. “We will have the equivalent of helicopters dropping money” he added.5
Thinking Beyond the Next Financial Crisis and Global Recession
At a global level, and particularly in the United States, some European countries, and in China, I am concerned with the rising levels of income and wealth inequalities that have surfaced over the last two decades. The levels of inequality we see today in modern economies are higher than the excessive levels last reached during 1929 in the US. According to the New York Times the richest 1% in the United States now own more wealth than the bottom 90%. This situation is not sustainable and its resolution could well be more disruptive than the next global financial crisis and recession.
1. Susan Lund, Asheet Mehta, James Manyika, and Diana Goldstein, “A decade after the global financial crisis: What has (and hasn’t) changed?”, McKinsey Global Institute”, August 2018.
2. Nouriel Roubini and Brunello Rosa, “Is the next financial crisis already brewing?”, Financial Times, September 11, 2018.
3. Chris Anstey, “JP Morgan Predicts the Next Financial Crisis Will Strike in 2020, Bloomberg, September 13, 2018.
4. Cristina Lindblad and David Rocks, “Why Are Economists So Bad at Predicting Recessions’”, Bloomberg Business Week, April 1, 2019.
5. Eugene Townes, ‘Dr. Doom’ Roubini Says China, Iran Will Lead World into ‘Severe Recession’, Money and Markets, July 2, 2019.
Primary Data Bases
6. IMF World Economic Outlook Database, April 2019.
7. BIS (Bank for International Settlements), BIS total credit statistics, updated April 2019. This data base covers 13 advanced countries (including the euro area as one country/region) and 21 emerging market countries, including China.