Data from historical crises post-Bretton Woods also shows that financial crises are commonly preceded by the build-up in leverage and imbalances in asset markets valuations, or, using more common language, by asset bubbles, linked to less liquid asset classes with more concentrated risk exposures.
In this sense, all evidence to-date points to a substantial increase of the next financial crisis in the global markets emerging since 2015-2016. Firstly, since the troughs of the GFC 2008 and the subsequent Great Recession, U.S. equity markets have rallied some 210% (if measured by the S&P 500 index), while other developed markets (excluding the U.S.) are up 70%, as reflected in MSCI EAFE index. U.S. Aggregate Bond Index data from Barclays shows corporate bond valuations up 45%, with Bloomberg Barclays U.S. High Yield index showing junk bonds’ yields down 690 basis points (bps). These valuations across the major asset classes are underpinned by the unprecedented expansion of the Central Banks’ balance sheets, by the increasingly complex and tightly coupled connections between the corporate credit markets and equity markets, plus the rising risk of market concentration in equities.
The three factors
In the decade since the depths of the GFC in September 2008, the combined balance sheets of the U.S. Fed, the ECB, the Bank of Japan and the People’s Bank of China rose from USD 7.7 trillion to USD 19.8 trillion, an increase of 156%. Much of this liquidity went to fund sovereign debt purchases. But, all of these funds supported to the downside the cost of corporate debt. As a result, U.S. corporate debt shot up from the pre-GFC peak of USD 6.5 trillion to USD 9 trillion today. Moody’s seasoned Aaa Corporate debt yields have fallen from around 580 bps average for 2002-2007 to below 390 bps average over 2016-present. Speculative grade corporate debt now accounts for well above 60% of all new debt issuance over the last 5 years. Covenant-light share of outstanding U.S. leveraged loans shot up from roughly 67% in mid-2015 to over 77% in mid-2018, according to the S&P Global Market Intelligence data. The Bank for International Settlements index of ‘zombie’ firms – tracking mature companies with EBITDA below debt-servicing costs, shows a five-fold increase in latent corporate insolvencies since 1985. Much of this increase is accounted for by the smaller firms, with some concentration in high leverage sectors, such as energy, oil and gas, and others. However, the index does not track the unicorn start ups in the tech sector, excluding a large set of new asset classes (private equity, VC, and start up equity and debt markets) that have material presence in today’s markets.
In simple terms, the post-GFC quantitative easing programs deployed by the major Central Banks have delivered a massive credit and equity boom, in line with the dynamics of the pre-GFC risk mispricing, and consistent with the traditional pre-crisis risk build-up dynamics.
The above also hints at the tighter coupling of debt and equity market risks. Ultra cheap credit available to corporate borrowers has fuelled more than a simple rise in equity returns performance that can be attributed to lower credit costs. Instead, the credit boom fuelled a massive shares buy-backs binge by the major corporations. Dividends and net buybacks have soared from the average of 0.023% of U.S. GDP over 1985-2005 period to nearly 0.05% in 2010-2018. Fuelled by the Trump Administration’s 207 tax cuts, the first 6 months of 2018, payouts as a percentage of GDP rose to 0.058%, more than two and half times higher than in the decades preceding the GFC. Per a research note published by the U.S. Fed last month, “In dollar terms, buybacks increased from USD 23 billion in 2017:Q4 to USD 55 billion in 2018:Q1.” Worse: “among the top 15 cash holders, the largest holders accounted for the bulk of the share repurchases: In 2018:Q1, the top 5 cash holders accounted for 66%, and the top holder alone accounted for 41%.” And, based on data from S&P, buybacks are accelerating in H1 2018, with Q2 2018 marking an absolute historical high at USD 1.0803 trillion (annualized rate) of share buybacks.
The U.S. and other advanced economies’ equity markets are becoming increasingly concentrated. Total Gross Issuance of Stocks, net of S&P500 share buybacks has fallen from the 1999-2004 average of near-zero to a negative USD 600 billion in mid-2018, based on the data compiled by Yardeni Research. Looking at the changes in the market cap of the 35 largest publicly listed companies since 2012, Facebook accounts for 56% of stock market gains, followed by Alibaba (29%) and Square (3%). High risk M&A activities—also driven by low credit costs—is further exacerbating the problem: per FactSet, “the first half of 2018 has reported the second-highest level of deals valued over USD 1 billion with 200 deals; the highest level was attained in the first half of 2007 with 210 deals. It is also worth noting that [since] 2013, …there have been over 100 billion-dollar deals in each half-year. Even in the run-up to the financial crisis the streak was only three years (2005 to 2007). And to help complete the pattern, the dot-com boom had a similar three-year streak of 100 billion-dollar deals in each half-year from 1998 to 2000.”
In simple terms, lax credit conditions, cheap cost of debt and reckless chasing of yields by the corporates, fuelled by the unprecedented money printing by the Central Banks over the period post-GFC has now inflated asset market bubbles well beyond the risk levels seen in the run-up to the last crisis. Today, virtually all financial markets are more reckless at mispricing financial and strategic risks and uncertainties, more concentrated and complex in terms of contagion pathways and exhibit more ambiguity and complacency in investors’ perceptions of the core risk dynamics than at any time in living memory. Unlike the dot-com bubble and just as at the time of the onset of the GFC, we are in an explosive VUCA environment of heightened volatility, uncertainty, complexity and ambiguity; the environment that has served as the basis for every single one of the past major financial crises.
Tricky timing
While the large scale, systemic blowout in the financial markets is no longer a prospect worth doubting, the timing of the next market collapse is much harder to predict. Thanks to the very cautious tightening of monetary policies, to-date, credit carry costs remain benign even for the financially fragile companies. And the recent experience with quantitative easing suggests that the central banks have acquired a virtually limitless willingness to continue underwriting fiscal and corporate recklessness into the future.
Cyclically, the U.S. economy (as well as that of the EU) is overdue a recession. Consensus amongst macroeconomic analysts suggests the recession around late-2020. It is highly likely that, given current forward guidance, the recession will arrive somewhat earlier, some time around the end of 2019-start of 2020, triggering a large downward correction in financial markets. Unless, of course, a different shock, arising from the ongoing problems in the financial and real economies across the emerging markets and China, leads us into a global downturn ahead of the U.S. and European one. Timing is a precarious game of guesses and ambiguity-rich analytical forecasts. That said, the fundamentals are now ripe for a Global Financial Crisis 2.0. History tells us, it is likely to be more painful than the previous one.
