- REUTERS/Stephen Hird
LONDON – Ten years on from the beginning of the financial crisis, things are looking pretty good for the global economy.
Growth is solid around the world, and greater regulation should, in theory at least, make a new banking crisis far less likely.
However, it would “take a huge leap of faith to say that crises won’t continue to be a regular feature of the current financial system that has been in place since the early 1970s,” Deutsche Bank wrote in a note last week.
The warning came in a note authored by famed strategist Jim Reid and his team examining all the possible global events that could be catalysts for a new financial crisis, if and when one arrives.
Deutsche Bank identifies 11 possibilities that could be the trigger for that new crisis. Events and issues include an excessively fast unwinding of the ultra-loose central bank policy that has characterised the post-crisis years, a crisis in China, and the failure of Japan – the world’s third-largest economy – to grow with any real strength.
Other risks include Brexit and Italy’s fragile political and economic situation.
Below are the most prominent risks identified by Deutsche Bank, as well as commentary from Reid and his team, below:
Italy’s unstable political and economic situation
- Deutsche Bank
Italy has three major problems that could threaten the country’s fragile stability. First is the rise of populism in the form of the Five Star Movement and its leader Beppe Grillo – a comedian turned activist. If the movement gains power it could destabilise the country’s international position.
Italy’s second major issue is its economy. Since the financial crisis, Italy has not been able to create sustainable strong growth and has seen its debt pile grow to the second highest of any eurozone country.
Debt to GDP stands at 133%, with only Greece, Japan, and Lebanon having higher ratios globally. Add to that a deficit of 2.4% and it means Italy must spend a substantial amount of money paying off interest on its debt obligations, as the chart above shows. It leaving the country vulnerable to default.
Finally, issues in the country’s banking system continue to loom large.
“The issue with economic growth is that growth requires a healthy banking system. Italy’s domestic banks have suffered greatly over the last few years having been poorly managed and riddled by stories of fraud and scandal,” Deutsche Bank’s team write.
- Jeff J Mitchell / Getty
Brexit could also help start the next financial crisis, Deutsche Bank warns.
While it isn’t likely that Brexit will go so wrong that it triggers a new crisis, Jim Reid and his team said, neither was the Second World War, and there are some similarities between these two scenarios.
“Through most of history, we tend to think compromise is always the most likely outcome when such differences exist and where there is the chance of mutually assured destruction,” Reid et al wrote.
“The extreme example being World War II when no-one really expected war, weeks and months before it arrived. How spectacularly wrong that assumption was. So it’s worth highlighting how Brexit could go wrong and create a financial crisis.”
Investors expect a deal to be struck – but nearly all of those in the British and EU establishment thought that Brexit wouldn’t happen at all.
‘(A lack of) Financial Market Liquidity…and changing market structure’
- Deutsche Bank
Markets are changing. Investment vehicles look different today compared to how they did 10 years ago. The clearest example is the growth of exchange-traded funds (ETFs).
An ETF is a passive fund which tracks an index and seeks to outperform a given index through frequent buying and selling of individual investments.
ETFs have seen a boom in the ten years or so since the last crisis, with growing numbers of investors opting to invest in ETFs rather than actively-managed funds, which are associated with higher fees and have offered lower returns over the last decade.
ETFs have grown rapidly, but their resilience has not really been tested by any significant market hardship, leading some observers to question if the sector will be able to cope with a substantial market correction should one come in the near future.
This is especially true when considering that some believe ETFs can distort the markets by encouraging investors to put money into big companies – simply because they’re big names – regardless of their market fundamentals (things like price-earnings ratios, return on equity etc.)
“The products warrant close attention particularly in the context of their surge in popularity for retail investors and as with any market still somewhat in its infancy, the real test is probably still to come,” the Deutsche Bank team writes.
Japan’s longstanding economic and social issues
- Deutsche Bank
Japan’s issues are neatly summed up by Reid and his team when they say: “The country continues to face the challenge of trying to manage large budget deficits, large QE and the highest public debt ratio in the developed world at a time when the population is falling and ageing (Figure 63) [above] with obviously fewer and fewer workers to pay the bills and more and more elderly to try to support.”
Deutsche Bank notes that most of the issues that face Japan are not exactly new. High debt, low growth, and an ageing population have been fixtures of the country for a long time.
“However that doesn’t prevent the problem being big and at some point the sustainability of the situation will surely manifest itself in either debt restructuring, much higher manufactured inflation or major monetisation of debt, in our view,” Deutsche Bank argues.
Central banks finally tightening policy, but getting it wrong
- Reuters/Joshua Roberts
Dubbed the “Great Unwind” by Deutsche Bank, central banks around the world are pulling back from the incredibly loose monetary policy that has characterised the years since the last crisis.
In the USA, the Fed has increased rates and is beginning the unwinding of its balance sheet, in the eurozone the ECB is starting to taper QE, and in Britain, the Bank of England could be on the verge of its first rate hike in over ten years.
“The ‘Great Unwind’ is a journey into the unknown and history would suggest there will be substantial consequences of the move especially given the elevated level of many global asset prices,” Reid and team write.
“Even if the unwind stalls as either central banks get cold feet or if the economy unexpectedly weakens, we will still be left with an unprecedented global situation and one which makes finance inherently unstable even if we are currently living in the lowest volatility markets on record.”
‘Are we out of bullets when the next recession arrives?’
- (US Marine Corps photo by Sgt Patricia A. Morris)
Perhaps the most worrying risk is that governments around the world are now unable to cope with any downturn, meaning a recession could quickly snowball into a major crisis.
“With Government debt levels spiking since the last recession, are politicians able to act as aggressively as they might need to?”
“Could the next recession be the one where policy makers are the most impotent they’ve been for 45 years or will they simply go for even more extreme tactics and resort to full on monetisation to pay for a fiscal splurge? It does feel that we’re at a crossroads and the next downturn could be marked by extreme events given the policy cul-de-sac we seem to be nearing the end of,” Deutsche Bank’s team writes.
A crisis in China
- Deutsche Bank
As the world’s second-biggest economy, and by the far the fastest growing major economy, China is a source of great interest to market participants. In late 2015, a minor panic rippled through global markets after “Black Monday” saw Chinese stocks plummet. That crisis was relatively short-lived, but the next panic in China could be a lot worse.
“China has been consistently talked about for years as being the source of the next financial crisis. Rapid credit expansion due to an insatiable demand for debt-fuelled growth, compounded by a hugely active shadow banking system, as well as an ever-expanding property bubble fuelled fears for economists that China could inevitably make a hard landing and send shockwaves through the world’s financial markets,” Reid and the other strategists write.
The chart above provides, in Jim Reid’s words, “a simple but striking snapshot of what China is faced with using the growth of non-financial debt in other countries with similar credit explosions and subsequent busts.”
The rise of populism
- Deutsche Bank
If 2016 was the year that populism entered the global political scene, 2017 will be the year that its impacts are fully felt.
With Britain’s exit process from the EU formally beginning and Donald Trump taking office in the US, populism will shape the global landscape over the coming years.
Following Emmanuel Macron’s overwhelming victory in the French presidential election in May, it seemed as though populism in Europe may be receding, but the Alternative for Deutschland party’s stellar performance in Germany’s election last weekend (after Deutsche Bank’s note was published) suggests otherwise.
“While the consequence of the recent rise in populism hasn’t yet destabilised financial markets, the level of uncertainty will surely remain high while such parties remain realistic power brokers in major national elections,” Deutsche Bank writes.
“Prior to the last decade, the only comparable rise in populism started in the 1920s and culminated in WWII. So although populism has proved unpredictable in recent years, the rise surely increases the risks to the current world order and could set off a financial crisis at some point soon.”