Will yesterday’s rescue be tomorrow’s risk?
The U.S. stock market is now 10 years removed from the financial crisis, which sparked a deep recession, resulted in millions of people losing their jobs and homes, and decimated the stock market, with the S&P 500 SPX, +0.37% losing more than half its value. Massive steps were taken by governments and central banks across the world to stop the crisis, but in what could become an ironic outcome, those measures may have simply laid the foundation for the next crisis.
That’s according to J.P. Morgan, which analyzed the causes of, and response to, the crisis in a recent note According to the investment bank, the economy remains propped up by the extraordinary steps taken in 2008, and changes to this environment — which have already begun, and which will accelerate next year — are an underappreciated risk.
A primary step taken during the financial crisis was massive monetary stimulus, including both the Troubled Asset Relief Program — where the government bought toxic assets from weakened financial institutions — and quantitative easing, where the Federal Reserve bought government bonds in order to lower interest rates and spur more investments and make equities more attractive. Overall, central banks bought some $10 trillion in assets.
“This accommodation is now expected to reverse, starting meaningfully in 2019. Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis,” J.P. Morgan wrote. “The main attribute of the next crisis will be severe liquidity disruptions resulting from these market developments since the last crisis.”
Changes to central bank policy are widely seen as a risk to stocks, which by one measure have been in the longest bull market in history since the bottom of the crisis. Barry Bannister, head of institutional equity strategy at Stifel, recently wrote that stocks were in “the danger zone,” and that rising interest rates could spark a bear market with “stocks falling faster than the Fed can react.”
Separately, the Fed has been reducing the size of its balance sheet, which swelled to nearly $4.5 trillion with the various rounds of quantitative easing. The unwinding of the balance sheet is seen as removing a steady drumbeat of equity support from Wall Street.
J.P. Morgan referred to its hypothetical scenario as the “great liquidity crisis,” and said that the timing of when it could occur “will largely be determined by the pace of central bank normalization, business cycle dynamics, and various idiosyncratic events such as escalation of trade war waged by the current U.S. administration,” the report read.
Changes to monetary policy will also have implications for the bond market. Since hitting a record-low below 1.4% in July 2016, the yield on the U.S. 10-year Treasury note TMUBMUSD10Y, -0.49% has climbed to 2.95%. That means that bond prices have dropped, as prices and yields move inversely to each other. If June 2016 does mark a turning point for the bond bull market, that could have significant implications for risk across asset classes.
“Over the past two decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. This increases tail risk for multiasset portfolios,” J.P. Morgan wrote. “In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets).”
Last month, Jeffrey Kleintop, the chief global investment strategist at Charles Schwab, warned that global levels of debt could exacerbate the severity of the next financial crisis.
Citing data from the International Monetary Fund, he wrote that global debt stood at $164 trillion at the end of 2016, the most recent period for which data are available. That represents 225% of global GDP, and growth of $50 trillion from pre-financial-crisis levels.
“While a high debt burden isn’t necessarily a problem by itself, it increases the vulnerability of the system to a shock — in particular, a shock that would lift interest rates,” Kleintop wrote. “In theory, all that debt means the potential losses from a rise in interest rates would be more costly than in the past, especially combined with a stronger dollar pushing up the cost of dollar-denominated debt outside the United States.”
J.P. Morgan didn’t forecast a crisis in the near term, saying that current imbalances in the U.S. economy were “ample but not glaring,” and that “the lack of severe imbalances suggests the next recession will be less likely to trigger a 2008-style crisis.” The most likely recession scenario, it added, “seems milder than 2008 and more akin to 1990 or 2001.”
Currently, it models a 25% chance of a recession starting in the next year, “not far from the historical average of 17%.”
