- There are sizable risks globally that could easily spark the next major economic crisis.
- The twin threats of a European banking crisis and the E.U. imploding is very real.
- While markets view Trump’s proposed economic policies with great enthusiasm and optimism there is also a dark-side them increasing the threat of stagflation occurring.
The optimism surrounding Trump’s proposed fiscal stimulus, higher oil prices, renewed growth in China and signs that Europe may finally be emerging from its prolonged economic downturn has propelled equities to new highs. Despite this considerable optimism there are a range of potential events that could emerge and cause havoc with the global economy and financial markets.
#1 Another European financial crisis
Recent data may indicate that the economy of the European Union is improving with recent data showing that manufacturing expanded in November 2016 at its fastest rate since April 2011. This according to pundits highlights that the Eurozone’s economic recovery remains intact and will progress into 2017.
Nonetheless, there are dire concerns over the health of banks in the E.U.
Italian banks remain mired with bad-debts that are worth approximately $400 billion which is 18% of the value of total loans under management and equal to a fifth of Italy’s GDP. It is also equivalent to 40% of all the bad-loans that exist in the Eurozone. To put this into perspective at the peak of the GFC U.S. NPLs only came to 5% of gross loans issued.
Exacerbating the issue is that Italy’s banks lack access to capital and the Italian economy is unlikely to provide any relief because it is a basket-case. Since 1995 GDP growth per person is lagging behind the rest of Europe and has actually contracted since 2009, when the rest of the continent started to recover.
In order for Italy’s economy to improve it needs healthy banks but the conundrum is that for the banks to generate sufficient earnings so as to boost their health they need a growing economy.
More worrying, is that Rome is not committed to fiscal responsibility and rectifying the situation in a sustainable manner. The referendum aimed at introducing constitutional reforms that were to reduce the potential for potential gridlock between the Senate and the Chamber of Deputies failed.
This prompted Prime Minister Matteo Renzi to step down creating further uncertainty as to whether Italy’s impending economic crisis can be averted.
Problem banks are not only limited to Italy.
Germany’s largest bank Deutsche Bank (NYSE:DB) in mid-2016 was rated by the IMF as the world’s riskiest bank with it estimated to hold up to $42 trillion in derivatives which is approximately 12% of the value of all derivatives outstanding world-wide.
There are ongoing concerns over the quality and value over those assets with the bank expected to continue incurring both losses due to their poor quality as well as legal and regulatory costs due to failures in managing risk. This particularly worrying for the global financial system because Deutsche Bank is a counterparty to virtually every major financial institution in the world.
If it implodes then it will sharply impact the derivatives market and asset prices which will ripple through virtually every major financial institution. Because Deutsche Bank is inadequately capitalized, lacks access to capital and is unable to boost earnings to as to reduce debt because of the ECB’s NIRP it is unlikely to be able to rectify its position any time soon.
If Italy’s banking system and/or Deutsche Bank implodes then the fallout would not only impact the Eurozone but spread across the global financial system possessing the potential to trigger the worst financial crisis since 2008.
#2 The collapse of the European Union
In the wake of the Brexit and rising populism and nationalism among member states of the European Union this has been a favored topic for many analysts. After the Brexit was announced many pundits were predicting that the E.U. was on the fast-track to collapsing.
Even Nobel Prize winning economist Joseph Stiglitz weighed in on the debate claiming that the Brexit changed the face of the Eurozone and increased the likelihood of its failure. Billionaire investors George Soros who once famously broke the Bank of England called the Brexit the final nail in the coffin for the E.U.
Then there is the increasingly hostile sentiment in member states that has arisen because of a perceived lack of control over immigration, declining standards of living and a lack of jobs. In some circles the E.U. has been described as the tyranny of the few lording it over the many.
This has seen both right left wing populist parties such as the far-right Freedom Party of Austria which came close to winning that country’s presidential election. Right-wing parties have also taken the reins of power in a number of European states and extreme right-wing parties such as France’s French Front National are enjoying incredible popularity. There are also the anti E.U. populist parties in Spain and Greece which have also enjoyed a surge in popularity.
This is threatening the cohesiveness on which the E.U. experiment relies to survive.
Renowned author of the Black Swan book Nassim Taleb has picked-up on these very sentiments when he predicted the collapse of the E.U. as far back as 2012 when it was in the throes of the sovereign debt crisis.
He stated that:
the entire world has grown tired of a sneering elite which has spent the last few decades patronizing the bottom 30% . . .
This reflects the attitude that has led to the rise of the populist parties on both sides of the political spectrum that wish to tear it apart.
There is also the ongoing damage that the ailing economies of some members is causing to the Eurozone and the Euro, with countries such as Italy desperately needing to find a way around the E.U.’s austerity rules in order to bailout its deteriorating banking system.
The founding architect of the monetary union Professor Otmar Issing earlier in 2016 warned that the Euro will fail and cause the E.U. to collapse stating:
One day, the house of cards will collapse, . . .
He then went on to say:
Realistically, it will be a case of muddling through, struggling from one crisis to the next. It is difficult to forecast how long this will continue for, but it cannot go on endlessly . . .
According to Issing the key culprit is the ECB’s willingness to bailout bankrupt states and not act with any fiscal responsibility.
Rather he believes that the ruling elite has sacrificed the legitimacy of the Euro at the altar of political expedience and are more concerned about creating a federal super-state that will reinforce their own power with the ECB merely being a lever used to reinforce that power.
Market discipline is done away with by ECB interventions. So, there is no fiscal control mechanism from markets or politics. This has all the elements to bring disaster for monetary union.
Clearly, if the Euro were to fail and the E.U. collapse the effects would ripple around the globe.
It would cast European economies into the economic abyss, cause incredible hardship for Europeans leading to the social and political unrest already being experienced in the Eurozone to magnify exponentially.
The impact wouldn’t be limited to Europe, it would cause a rout in financial markets and likely trigger a global financial calamity of epic proportions. The E.U. as single entity is the second largest economy globally, responsible for approximately 22% of global GDP. It is also the largest trading partner for the U.S. and the second most important export market for China, the world’s largest exporter. The impact on those economies would be huge and it would certainly end Beijing’s dreams of achieving annual GDP growth of 6.5%.
Then there is the specter of a breakup of the E.U. unveiling all of the economic fissures that exist in the region and the likelihood of it triggering a Eurozone banking crisis. While the jury is out as to whether the E.U. will collapse, if it does the global economic slump will be deep and prolonged affecting every developed and major emerging economy.
#3 The re-emergence of stagflation
One of the greatest risk being faced by the U.S. economy is the re-emergence of an old 80s favorite stagflation. It hasn’t been since the early 80s inflation which caused gold (NYSEARCA:GLD)(NYSEARCA:IAU) to soar to its highest inflation adjusted price ever that the U.S. experienced a major bout of stagflation. Stagflation is an economic condition characterized by high unemployment, stagnant economic growth and rising inflation.
It emerged in the late 70s triggered by the combined effects of weak economic growth, lack of fiscal discipline, the oil shocks which caused energy prices to skyrocket and a marked decline in business competitiveness. And it was this that led to the early 80s economic crisis and recession.
Now Trump’s proposed fiscal stimulus, trade policies, rising interest rates and weaker corporate pose a very real risk of triggering stagflation. Trump’s planned fiscal stimulus if implemented would more than likely cause the federal deficit to blow-out by as much as US$10 trillion over the next decade, leading to higher borrowing costs and reduced savings.
Then there will be the impact of higher borrowing costs created by a conflation of higher interest rates and rising bond yields. To prevent the economy from overheating the Fed will raise interest rates and given the degree of concern Fed officials have already expressed over trump’s aggressive fiscal stimulus, it is possible that they will increase the tempo of rate hikes in an attempt to prevent the economy from overheating. This will not only stimulate the U.S. dollar but also in conjunction with the pullback of monetary stimulus cause bond yields to rise sharply.
Rising bond yields when combined with higher interest rates will cause the costs of funding to rise markedly.
When this is combined with the other effect of higher interest rates and a stronger U.S. dollar U.S. businesses will suffer from margin compression and become less competitive internationally. This will make it unattractive for businesses to borrow and use those funds to expand their operations and invest in growth, which is one of the key drivers of economic growth.
It is also worth sharing the opinion of an Seeking Alpha author whose opinion I hold in considerable respect Shareholders Unite. In a recent analysis of black swans Shareholders Unite succinctly describes the conditions that could trigger stagflation making the following points:
Because the U.S. labor market is close to full employment any additional fiscal stimulus led economic growth will cause wages to rise sharply causing prices to rise, creating further inflationary pressures.
Growing concern by the Fed over the potential of this type of situation emerging increase the likely hood of further rate hikes.
Declining productivity coupled with demographic influences means that the U.S. economy can only grow at 2% annually, capping the amount of real economic growth that can be achieved in what is shaping up to be a highly inflationary environment.
It is also worth noting that this magnifies the margin compression discussed earlier, further disincentivizing business to invest in growth.
A higher U.S. dollar which will impact the profitability and competitiveness of U.S. enterprises, placing even greater pressures on margins and business growth, thereby further hurting economic growth.
Each of these factors, would certainly cause economic growth to decline and if Trump does implement his fiscal stimulus including the massive trillion-dollar investment in infrastructure it could create a lop-sided economy driven by unsustainable government spending rather than a growing private sector.
Besides these factors rising oil prices and the growing potential for oil shocks because of widening geopolitical fissures and increasing conflict in the Middle-East would place greater pressure on prices at the pump and for transportation. This would magnify the impact of the events already discussed and cause inflation to spiral higher while placing pressure on economic output.
It was these types of events that were directly responsible for the massive bout of inflation experienced by the U.S. in the late 70s.
There is no guarantee that any of these events will occur but the potentially certainly exists and they are events that every investor needs to be cognizant of and hedge against. During the last major bout of stagflation in the late 70s which was responsible for the early 80s recession, one of the best performing assets was gold. The twin effects of rising inflation and economic crisis served to propel gold to its highest inflation adjusted price ever, hitting $850 per ounce in January 1980.
While I am not convinced of gold’s role as a hedge against inflation nor its inverse relationship with interest rates it has historically performed well during times when geopolitical and economic crisis have conflated to create highly stressed conditions. Probably the most effective means for long-term investors to manage these black swans is to ensure that they are not fully invested and have cash on hand to take advantage of the deep market downturn that such events would trigger.
Reference article – https://seekingalpha.com/article/4034329-3-black-swan-events-wreak-havoc-2017?page=2