It will happen again. Almost 10 years since the collapse of Lehman Brothers and the global financial crisis, Deutsche Bank issued a cheering note pointing out that another financial crisis will happen, and that it will be worse than the last.
In a new iteration of an annual study, titled 'The Next Financial Crisis', Deutsche's European strategists identify 11 potential things that could cause disaster between now and 2020. These we have listed below. Given that the last crisis eviscerated banking jobs (eg. American banks and insurers slashed 400,000 between 2008 and 2013), you might want to take note.
DB's strategists suggest we're in the early stages of the "great unwind." Since the financial crisis, $10 trillion+ has been added to the balance sheets of the four largest central banks, which now over $14 trillion of assets. As the charts below show, this is unprecedented. Deutsche notes that in just over two years the ECB has printed the same amount of money that it’s taken the whole 1.3bn Indian population to produce economically in a year.
This situation needs to change. The trouble is that central banks will be unwinding their monetary stimulus into a situation where global debt is at all-time highs - particularly at government level. How will the economy cope without it?
Central Bank Assets (inflation adjusted to June 2017 price levels) – Four largest (left) and only Fed and BoE (right)
DB strategists say the danger is that this "great unwind" takes place just as economic growth sputters and dies. With government debt already high, will governments be able to afford to replace monetary with fiscal stimulus? Will they go for full monetisation of their debt (ie. buy the debt with printed money and never pay it back in a form of self-funding)?
Something has to be done: Deutsche says people in the lower half of the income scale will no longer tolerate stagnating wages. As fiscal policy and debt monetisation take over, Deutsche sees inflation making a comeback. The fraught combination could cause a crisis as the economy adjusts.
As an alternative to debt monetisation, Deutsche says governments could continue to rely upon quantitative easing (in which central banks buy debt but promise to sell it on again later). This could risk a return to negative rates and worries about the stability of the financial system.
Deutsche says Italy is a disaster waiting to happen. It has high populist party support, a perpetually under-performing economy, a comparatively huge debt burden, and a fragile banking system which continues to have to deal with legacy toxic debt holdings. If anything goes wrong with the global economy, Italy will be very exposed. In particular, Italy's export sector could struggle as the euro rises.
Deutsche says Italian banks still have €349bn of gross non performing loans. The good news is that most of these are at Italian banks now supervised by the European Central Bank.
Italian Government Debt to GDP
If it's not Italy, it could be China. Deutsche notes that credit growth in China averaged 20% on an annual basis over the last 7 to 8 years, far outstripping the pace of Chinese GDP growth. The country has a huge property bubble and growing tensions from social inequality.
"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," are China's main issues, say Deutsche's strategists. They point to a study by the IMF which shows that other countries with credit booms like China's have historically had hard landings.
Since the end of the gold standard in the early 1970s, Deutsche notes that global trade has increased dramatically and that more countries have substantial current account surpluses and deficits (see the charts below).
"We live in a world where huge cross border flows are essential to fund the status quo," note the strategists. "As such this surely makes the financial system more crisis prone as domestic policy makers have less control of their own economy."
G20 (including EU) Current Account Balances (Net, % of GDP)
Current account balances (most recent figures, % of GDP) – ordered from largest surplus (left) to largest deficit (right) with G7 countries shaded
We've had the Brexit vote. We've had the Trump vote. Within the next nine months, Deutsche notes that we will also have Italian elections where the anti-establishment “Five Star Movement" could gain a foothold on power and destabliize Europe. At the same time, they say Trump could yet exert U.S. military might in Asia and cause "great friction" with China. All of this risks an "extreme event" that could disrupt the financial system.
Deutsche says current asset prices are possible at their "most elevated in aggregate" throughout the whole of history. A sudden correction cannot be ruled out.
Aggregated 15 DM country average bond (nominal yields) and equity percentile valuations (100% = most expensive; 0% = cheapest)
Japan's been scraping along at rock bottom for a while now, but this doesn't mean things there can't get worse. Deutsche notes that the country still has large budget deficits, still has huge QE, and has, "the highest public debt ratio in the developed world at a time when the population is falling and ageing with obviously fewer and fewer workers to pay the bills and more and more elderly to try to support."
In these circumstances, the strategists say it's almost impossible to see how Japan can get onto a sustainable path without massively increasing retirement ages, quickly repopulating, or "resetting" inflation.
Sterling's already fallen 19%, but DB's strategists say this is nothing compared the crisis that could unfold if the UK's relationship with the EU breaks down completely. This would have economic and geopolitical implications - to say nothing of the liquidity implications from the isolation of London markets.
Lastly, Deutsche points a finger at declining market liquidity. Market makers' holdings of inventories have declined substantially since the last financial crisis. This could cause a problem if there's a "change in the yield" environment and banks can't facilitate trading because they now only match buyers to sellers rather than buying securities to sell them on. If there are no buyers, for example, prices could fall dramatically.
Deutsche notes that a lot of market activity has shifted to exchange traded funds instead. However, these have not yet been fully tested in a sustained bear market and could make things even worse.
Average daily trading volume as % of market size in US HY and IG
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Photo credit: Lost by Wendelin Jacober is licensed under CC BY 2.0.