What will cause the next financial crisis?

Ten years after the collapse of Lehman Brothers, I asked our editors what could be the “subprime mortgages” of the next crisis.

Tomorrow it’s 10 years since Lehman Brothers bit the dust.

The demise of the fourth largest investment bank in the US is widely seen as the start of the global financial crisis.

That crisis caused a world of pain.

Jobs were lost. Markets fell. Banks were bailed out with taxpayer money.

Things like that aren’t easily forgotten…

Which is why on this anniversary everyone in finance is asking if we should expect another crisis anytime soon.

On the surface it doesn’t look like we have a lot to worry about at present.

The economy is picking up steam (in the UK and US anyway), wages are growing at last, and stock markets are breaking one record after another.

And yet sentiment isn’t overly optimistic.

For all the central bank talk that they’ve “fixed” things their policies still very much scream emergency mode.

Debt levels are now as high as they were before the last crisis.

And even if crises don’t occur every ten years like clockwork, a nine-and-a-half-year bull market does make us wonder if we’re due another crisis soon.

So on the 10-year anniversary of the last crisis, let’s have a stab at predicting what might cause the next one.

Mark Carney’s four biggest headaches

A crisis can’t be predicted, only observed.

Or as Warren Buffett, who knows a thing or two about the markets, likes to put it:

“Only when the tide goes out do you discover who has been swimming naked.”

Predicting what will cause the next financial crisis may therefore seem like a fool’s errand.

But we don’t mind looking foolish from time to time.

And surely there’s no harm in taking a long hard look at the world of finance and see if anything’s looking a little wobbly.

Mark Carney, governor of the Bank of England, was already asked about the biggest dangers to the UK economy in an interview with the BBC this week.

He listed four threats, three domestic and one global, that could hurt the UK.

“The level of debt is still relatively high … and there are pockets where there is quite significant debt. What we get concerned about is those areas taking on a lot more debt.”

Household debt is problem number one. What else?

“There are risks around Brexit for the financial sector.”

Yes, you’ve mentioned that before.

“The third class of risk, which is new, in the last decade is risk related to cyber security…

“If a bank were to be knocked out because of a cyber attack, how do we keep the system functioning in that event?”

Now, for the global threat…

“One of the bigger risks for the global economy are developments in China.

“Their financial sector has developed very rapidly and it has made many of the same ‘assumptions’ that were made in the run up to the last financial crisis.”

Carney also takes the time to pat himself on the back (somebody should, right?).

He says the central bank is now “absolutely upfront about those risks”, naming stress tests for banks as an important change that’s made the system safer.

For the sake of convenience, the governor leaves out that “too big to fail” banks have become even bigger and now pose an even larger threat to the system.

But don’t worry, he says, next time there’s a crisis it’s big investors who will be footing the bill. Taxpayers have nothing to worry about.

What our editors think

It’s all well and good for Mark Carney to list the four biggest threats to the UK economy in his eyes…

I mean he’s presumably anticipated all those dangers otherwise he wouldn’t mention them.

But the problem is that though central bankers act like money gods by creating trillions out of thin air, they’re not omnipotent.

A crisis can start in an area they have little or no control over and spill over to the rest of the system. Or it may stem from an area that’s been blatantly overlooked.

In short, we’re looking for this decade’s “subprime mortgages”.

With that in mind I asked our editors where they fear the hurt might be coming from this time around.

Here’s what they said…

Pay packets

David Stevenson, contrarian investor and investment director of Strategic Intelligence and Untapped Fortunes, has identified something apparently mundane as a potential source of trouble: your pay packets.

After years of stagnant – or no – wage growth, the world’s workers are getting their own back. Pay packets are finally growing, both in absolute and real (inflation-adjusted) terms.

Here in the UK, annual regular earnings growth rose from 2.8% to 3.1% in July. That’s the fastest pace since July 2015 and a joint post-crisis high. Underlying pay growth has just reached its joint-highest pace since 2008.

Let’s put this into context:

In recent years, real UK wage growth has been at its slowest since the 19th century.

It’s been a similar trend elsewhere in the world.

But a significant earnings upswing could send inflation higher and force central banks to hike interest rates, just as economic growth is generally slowing.

For the stock market, falling wages as a percentage of GDP have been a major boon. But a reversal of that trend would eat into company profits and drive up long-term interest rates.

The massive equity/bond bull market that’s lasted almost 40 years could be coming to an end.  

And it’s in the nature of markets to move very quickly.

So don’t be surprised if central banks suddenly panic over increasing pay packets and financial assets values take a major hit.

US stocks

Greg Robinson, income investor and investment director of Income For Life, sees the unsustainable US stock market levels as the main thing to watch.

The S&P 500 over the last ten years. Does that look sustainable to anyone?

Cheap money, corporate tax cuts and a lack of alternative investments have pushed the US stock market to nosebleed levels (CAPE = 32).

It makes me think that most participants are hanging in there ‘knowing’ that it will crack soon. They are just trying to eek out a little more before it turns.

When the next event triggers a sell off, it wouldn’t take much for a panic to set in because everyone is expecting a crash, and it will become self-fulfilling.

I don’t know what the trigger will be, but when this blows, I suspect it will go big time.

And you can guarantee our domestic shares will be dragged down along with their US cousins.

Cack-handed policy

Sean Keyes, small-cap investor and editor of Technology Profits Confidential and Microcap Millionaires, seems the least worried of our editors.

He’s not particularly concerned about failing banks or booming stock markets at this time…

Almost everyone agrees that stock market valuations in the US are too high. I’ll make the case that they’re not.

Stock yields and bond yields tend to move together. When bond yields are falling stock yields will tend to be falling too.

And another way of saying stock yields are falling is that stock valuations are rising.

But the thing is, yields have been falling steadily since 1980 or so, on both stocks and bonds. This isn’t a new story. What’s going on?

One answer people give is “loose monetary policy”. But this can’t be right. The timing is wrong. It’s been happening for 35 years or so, long before so-called loose monetary policy kicked in. 

I think yields are low / valuations are high for two main reasons. 

  1. Inflation expectations are low, which has pulled down yields and pushed up valuations.
  1. Supply and demand. There’s now much more savings out there hunting for yield.

Low inflation expectations and increased demand for investments = lower yields and higher multiples.

So Sean sees a logical explanation for stock market highs and doesn’t think they’re necessarily going to cause a new crisis.

But the question is, what might?

Bank leverage is a lot lower, that seems significant.

I do think these crises are usually nothing more than cack-handed too-tight monetary policy. So that’s always a risk.

As sure as ebb must follow flood, an economic peak is followed by a recession.

As we’re reminded this week, it was Lehman that was caught without a bathing suit last time around…

We may not have to wait long before we know who is skinny-dipping now.

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