Global Financial Instability: Never Before Has The World Been So Dangerously Volatile - My Economy Notebook

by: Dennis Viliardos

Summary

Ex-BIS Economist who had predicted the 2008 market crash now says current conditions are far more dangerous.

The continuously growing debt might trigger a major domino effect if no solution can be found to reduce it before the next recession.

In Europe, banks sit on a pile of bad debts, equal to 1 trillion euros, while shadow banking keeps investors in the dark.

A bond crisis is unraveling, with U.S. high yield bond rates doubling over the past 1.5 years.

Debt and no growth, a vicious spiral - I

William R. White, previously head at BIS and currently operating under the umbrella of the OECD, is a Canadian economist who had successfully predicted the coming of the 2008 market crash. He did so before the 2007 subprime loan crisis unraveled. Today, he strongly believes that the global financial system is in much worse condition than it was then, with central banks having used up all the ammunition to counter a recession. In 2007/8, central banks had not interfered directly as they have now and that is what distorted real market prices, making the next market crash invisible and unpredictable.

He also noted that global markets will have to survive a major "wave" of bankruptcies. Central bank easing programs (QE) added to the continuous rise in debt. The fact that debt (government, business and household debt) has not decreased over the period of low interest rates, will make it harder for businesses to survive future rate hikes.

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So no later than the next world recession, it will become clear that this piled up debt cannot be serviced, let alone be repaid. The Greek crisis can be used as an example, to illustrate how a recession (depression) pushes debt further up. The combination of a high private and public debt, makes it impossible for a country to re-balance its economy without a write off.

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Graph description: After Greece entered a recession that eventually developed into a severe depression (losing more than 25% of its GDP), debt kept increasing. The blue circle points out a debt "hair-cut" that took place but which did not help much (83% of bond holders that took on the loss were Greek investors).

Based on the graph above, we can understand that the real problem today is global debt. Debt was not a major concern in all previous market crashes. At the same time, central banks had not intervened to "save the day" back then either. So unless we witness change, a major stock market crash will always be a possibility.

By change though, we do not just mean a write-off. As in the case of Greece and Argentina, a debt reduction effect only lasts for a limited period of time. The real problem we investors must focus on for the long run (especially long-term investors in the retirement process), is the unbalanced redistribution of income. As long as lower income classes fail to pick up, consumption will continue to plummet and so will investments (made by corporations that depend on retail sales etc.) and growth prospects (this is particularly evident in the U.S., where retail sales continue to decline).

For example, if the income of a person is being reduced from $1,000 to $700, he will have to cut back on spending at once. On the contrary, if someone's income drops from $1 million to $700,000, his consumption habits will be little changed. Same goes if the above person's income moves up to $1.3 million. What does change in his case, is the increase or decrease in investment positions he initiates. The upper class therefore is never really the reason consumption fluctuates. Hence, a good measurement for the future prospects of an economy is to follow income dissemination developments per class.

In order to further support this rarely used metric (for long-term investment purposes), we should also add that lower income for the average consumer translates into increasing bad loans for banks and unpaid obligations for governments. In the end, major negative changes in the redistribution of income pushes governments, businesses and households towards bankruptcy. Indices decline, currencies fluctuate and businesses change their dividend policies in accordance with real economy developments, which can be measured by the metric we just mentioned.

*Note: Overall, we have three metrics (rarely used, although quite precise) to assess an economy's state for various time frames: (A) the development in the redistribution of income (income of lower and middle classes vs. upper class) is measuring long-term real economy developments, which will eventually be carried over to the financial economy (stock market, bonds, commodities). (B) The developments in bad debts pretty much give us a sense as to how much longer households (the base of an economy) can sustain themselves and therefore also banks. This would be a medium-term assessment of the state of the economy. (C) The development in investments and new loans made is a semi short-term assessment of an economy, which would be a much more drastic metric if central banks had not intervened directly.

Shadow Banking, keeping investors in the dark - II

In my previous article ("How stock indices lie to you"), I pointed out that low interest rates have solved nothing but have rather increased global debt in every sector. Now that the Fed has started hiking (others will follow), the debt pile is becoming more expensive - and so is any effort to refinance it.

In the same article, I also explained that indices have kept rising for reasons other than company earnings results. Central bank intervention (QE) has inflated markets and so have some real economy developments (banks reduced lending to businesses and instead invested in the stock market).

So a major market crash is still a reasonable risk, especially if no solution to global debt is found and income inequalities continue to exist (major inequalities). Yet, on a short time basis, markets might witness an uptrend (February, March), especially since the ECB has said that it will do "anything that is necessary" to support current conditions - translation: a new QE program.

The reign of central bank power though will come to an end and many professionals already notice that markets do not react as favorably to new policies as they did in the past. An example would be the developments that took place after the Fed started increasing interest rates and when it hesitated during the "second round."

Added to the already problematic and fluid market environment, is another financial bomb of great caliber, namely the banking industry and specifically its "shadowy" segment. Shadow banking has recently troubled many governments, since on average it has reached the incredible size of 59% when compared to the world's GDP.

The definitive no.1 in this segment is Ireland (see graph below), the country that is currently being praised as the "tiger" of Europe, having been able to "manage" the IMF and get rid of memorandums. Great Britain and Switzerland follow the example, giving us additional knowledge on the subject I covered in my previous article - namely that the financial system isn't what it seems and that we usually only scratch the surface.

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Source: DGB/Financial Stability Board

A lot of things taking place "in the shadows" are not available to us average investors. Hence, one must comprehend that we are at risk to an extent directly proportional to this gap in data. The risk we take on is increasing even further, if we take into account that for example European banks lie on a pile of bad debts that is equal to about $1 trillion in value. At the same time, these very same banks are exposed to emerging markets (developing economies) that currently face a major currency crisis among other issues. This is the reason we witness so many lay-offs in the banking industry and why suddenly various losses make their appearance out of nowhere (how these losses are being presented is a story of public relations).

Two examples that reveal the fear that is instilled in the banking industry are Barclays's move out of emerging markets and Italy's continuous effort to avoid engaging with an internal banking rescue scheme (bail-in) in order to confront its "bad debts crisis." There are of course plenty of other examples (UBS, Credit Suisse, Deutsche Bank etc.).

Bond Crisis, Central Bank dead-end - III

Continuing our discussion on the major problems that need to be solved in order for the world economy to bounce back, we must first realize that although central banks might have succeeded in confronting the liquidity crisis, they are not capable of dealing with the credibility crisis.

The bond market has a particular sensitivity when it comes to bankruptcy risk and low credit ratings. If a company or government were to be rated negatively (at least by markets themselves), the cost of borrowing or interest rates would spike very quickly and without warning.

After mid-2014, the U.S. high yield bond market, for example, witnessed a tremendous change that has put many sectors in danger. The graph below depicts just that, namely how bond yields more than doubled within a matter of months.

As we can see from the graph, the first major column (U.S. corp. high yield), that depicts the average development in all sectors, shows that yields have increased from about 5% to almost 10% in just 1.5 years. A more careful look into specific sectors, informs us that the energy sector has been particularly hit from the oil crisis (from 5% to 19%!). Other sectors that have seen their yields climb immensely are the basic industry sector (naturally) and the transportation sector.

Current circumstances in high yield bond markets can from one point of view be seen as a rare buy opportunity. Of course, there are many analysts that believe the particular market will be filled with bankruptcies, especially if Morgan Stanley's reports are to materialize.

Conclusion

Time will show how markets will perceive conditions (after all the basic rule of demand and supply holds even in the development of stock prices), but unless we see some meaningful changes in the three parts this article presented, risk for a major drawback in all markets remains a reality - not just a possibility.

It seems that no region of the world has actually recovered after the 2008 financial crisis. The markets have changed and simply looking at corporate reports will not be enough if economic and macroeconomic factors are not mixed in. In general terms, currency crises and further turmoil will characterize the years 2016 and 2017.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.