Here’s what could trigger the next financial crisis

When will the next financial crisis happen and what will be the cause? It’s a question permanently on the lips of investors the world over. The first half of the question is impossible to answer accurately, of course, but one expert has had a crack at guessing the likely causes, which may help with the “when” bit.

Deutsche Bank’s Jim Reid and his macro strategy team devoted its most-recent long-term asset return study – all 94 pages of it – to the subject.

While crises have been a feature of financial markets throughout history, Reid observes that the current global financial system remains as vulnerable as ever. The chart below, showing occurrences of financial crises throughout history, bears this out.

Examples range from the UK secondary banking crisis in 1975 to the Japanese stock bubble bursting in the 1990s, right through to the most recent global financial crisis and European sovereign debt crisis.

“It would take a huge leap of faith to say that crises won’t continue to be a regular feature of the current financial system,” says Reid. “The near exponential growth of finance and its liberalisation since [the early 1970s] has encouraged this trend.”

Currently, there are many features running at extreme levels, and Reid believes that “if there is a crisis relatively soon, it would be hard to look at these variables and say that there was no way of spotting them”.

That said, crises tend to have a large element of unpredictability, making their imminent arrival hard to foresee. “History tells us that there is still a chance that when the next crisis comes its origin will take us by surprise. As will its timing.”

What to watch for

So, what event are most likely to precede the next financial meltdown? Number one on Reid’s 11-strong list is the forthcoming central bank unwind. “We are at a unique point in time with regards to the relationship between debt, interest rates and central bank balance sheets,” he explains.

The four largest central banks have boosted their balance sheets by $10 trillion and snapped up $14 trillion worth of assets since the financial crisis. Combine that with historically high G7 government debt and interest rates at all-time lows and markets have a nice safety blanket.

This is in the process of being pulled away as central banks reduce their balance sheets, wind down quantitative easing (QE) and hike rates. This is a “journey into the unknown” with potentially “substantial consequences”, especially given the elevated level of many global asset prices.

On a country level, Reid says Italy “ticks a number of boxes” as a potential source of financial crisis, as it continues to battle political turmoil, a huge debt burden and a fragile banking system still dealing with legacy toxic debt holdings.

China continues to defy predictions of an inevitable hard landing, but at the expense of massive leveraging and “future growth cannot forever rely on debt and investment alone”.

Japan has also previously been touted as a candidate, and Reid says: “It’s easy to get complacent that as one hasn’t happened to date, one can be permanently avoided”.

However, now the country continues to face the challenge of trying to manage large budget deficits, large QE and the highest public debt ratio in the developed world, at a time when the population is falling and ageing. This is concerning.

Everything’s pricey

Asset prices remain at elevated levels. In fact, the chart below shows Deutsche’s analysis of a portfolio comprising 15 developed market government bonds and 15 developed market equity markets tracked back as far as 1800.

According to this, financial assets have never been more expensive. This is led by bond prices, with zero long-term value relative to history. Equities, meanwhile, are nearing peaks not seen since 1929, 2000 and 2007.

While a correction is inevitable at some point, Reid points out that a crash does not appear to be imminent. That said, “there is always a risk of a sudden correction that could be destabilising to a financial system and global economy that seems to require such elevated asset prices”.

Finally, the discussion would not be complete without reference to Brexit. In fact, a 19% fall in sterling versus the US dollar does count as a financial shock.

However, a greater crisis will occur should we get a ‘hard Brexit’. “This would not only have economic implications for the UK and the EU, but also on geopolitics.”

While Reid believes a compromise will be reached, Brexit “has introduced a major risk to economic activity, the financial architecture of Europe and perhaps more concerning, the geo-politics and security of the region”.

Other catalysts include the lack of financial market liquidity, a lack of bullets for when the next recession arrives, inflation continuing to disappoint, elevated global imbalances and the rise of populism.

Reid concludes that he is “confident that there will be another financial crisis/shock pretty soon” and that “their frequency [will] continue to be high until we create a more stable global financial framework”.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.