By Cormac Lucey
It is 10 years since the Irish government’s fateful decision to guarantee the liabilities of the Irish banks. That rubber-stamped the country’s plunge into financial disaster, following the collapse two weeks earlier of Lehman Brothers, which kickstarted the international financial crisis.
As with all meltdowns, there had been plenty of warnings. The share price of Bank of Ireland, the Irish lender that suffered proportionately the least damage from the crisis, had already dropped 75% from its peak prior to September 2008.
The essential ingredient of the crisis was too much debt. If asset prices fall and the owners of those assets owe nobody else any money, they are in a position to sustain the losses themselves. If asset prices fall and the owners have borrowed to fund those assets, lenders may intervene to force a sale before losses grow to the point where their repayment would be jeopardised. Distressed asset sales can trigger further price falls, forcing more distressed sales and, soon, we have a contagion of debt deflation.
While our authorities are at pains to suggest a financial crisis can never happen again, I believe, for two reasons, we are much nearer to the next downturn than the start of the current recovery.
First, every significant American recession in the past two decades has struck following a large fall in the unemployment rate, when it has dropped below 5%. Unemployment in the US is now 3.8%. My second reason for concern is that the yield curve is approaching inversion in the US, meaning long-term bonds will have a lower yield than comparative short-term bonds.
The good news is that the downturn may be some way off. Studying the two signals above suggests the next US recession might occur in 2020, with the stock market peaking maybe six months earlier — towards the end of 2019 or in early 2020.
In February, BCA Research, a Canadian research group, shifted its US recession call from late 2019 to 2020. Earlier this month, the billionaire hedge fund manager Ray Dalio predicted that the US economy was about two years from a downturn, which would suggest late 2020. Many of the themes of the next global downturn are likely to be similar to the last one, but I think they will play out in different ways. For starters, it will be another crisis rather than merely a downturn.
At a global level, I expect it to be a significantly bigger crisis with a deeper economic impact than 2008. There will, though, be some big differences between the next crash and the previous one.
The world will enter the next crisis with even higher debt levels than in 2007. According to the Bank for International Settlements, an international think tank of central bankers, global debt at the end of 2017 equalled 217% of global GDP, up from 179% in 2007.
Policy-makers fought a debt crisis by encouraging more debt through lower interest rates and quantitative easing. As a result, the global economy is now more financially fragile than a decade ago. That’s the main reason why I think the next international crisis will be worse.
Things are better here in Ireland. Our debt levels are far lower than a decade ago. Compared with modified gross national income, the national debt is 111%, down from its peak of 166%.
Household debt too has fallen dramatically: down from 215% of after-tax income levels to 140%. In an international context, it remains high, but with credit being sucked out of the economy over the past decade, there been little opportunity for credit-induced imbalances to develop.
The economic recession of 1990 was largely focused on Japan; in 2000, imbalances were centred on tech and telecoms; the 2007-8 bust reflected the US mortgage and credit boom. Today, we have bubbles in everything.
Wherever you look — equities, bonds, property, developed markets and emerging markets — asset prices have reached levels not seen before in two centuries of observed data. The current recovery has involved a far broader rise in asset prices than normal, coupled with a far greater degree of central bank intervention than could have been imagined a decade ago. Consider two extraordinary consequences of quantitative easing: in April it was reported that the Japanese central bank owned 74% of equities on its country’s stock exchange; and the largest owner of Facebook A-shares is not Mark Zuckerberg but the Swiss National Bank.
What goes up doesn’t necessarily go down. That’s especially the case if central banks are forced — by high debt levels and weak economic output — to keep interest rates at a permanently low plateau.
Yet it’s hard to imagine that an international downturn won’t convert a bull market in everything into a bear market in everything.
Some technical market developments over the past decade have added significantly to underlying risk. Share buybacks play an increasing role in the volume of stock exchange transactions.
According to Goldman Sachs, aggregate share buybacks rose by nearly 50% to $384bn (€327bn) in the first half of 2018. That exceeds the $341bn that went on capital expenditure. One problem with buybacks is that their volumes are pro-cyclical, so they are at their greatest when stock prices peak and at their least when prices trough, thereby adding significantly to equity market volatility.
Another factor is reduced market liquidity, meaning a fall in the volume of transactions and the availability of a buyer when you wish to sell. A 2015 PwC report on global financial liquidity concluded: “The current market evidence points to a measurable reduction in financial market liquidity.” As an example, it pointed out that European corporate bond trading volumes had declined by up to 45% between 2010 and 2015.
Who will organise a globally coordinated response to the next crisis? A decade ago, the American, British, European, Chinese and Japanese authorities responded to the threat of a global depression in a co-ordinated spirit of partnership. In the Donald Trump era, would such co-operation be possible?
Earlier this month Gordon Brown, the former UK prime minister and chancellor of the exchequer, warned: “We are in danger of sleepwalking into a future crisis . . . There is going to have to be a severe awakening to the escalation of risks, but we are in a leaderless world.”
Each of these four differences suggest the next international crisis will be worse than the previous one. It may still be 12-24 months away and its impact in Ireland should be considerably less than last time, but it will still be considerable. For corporates, it is probably the time to be selling assets rather than buying or investing in them.
Published in The Sunday Times (Ireland edition)
September 30th 2018