Rothschild: The Next Financial Crisis? Wait For It…VW Staff
The Next Financial Crisis? Wait For It… via Rothschild Wealth Management
Cyclical and secular risks
“I have learned from my mistakes, and I am sure I can repeat them exactly.” – Peter Cook
The next financial crisis? Wait for it…
There will surely be another financial crisis at some stage. But while many assert that the global financial system is a house of cards and a collapse is imminent, we disagree.
For one thing – and at the risk of tempting fate as we move further into the seventh year of the current US expansion – we think the next cyclical downturn may lie still on the other side of the visible investment horizon.
Regular readers need not worry: we are not about to start making explicit short-term forecasts. We just think the global “muddle through” can continue for a while longer. It is too soon to call the end to the current business cycle.
For another, we think the next financial crisis, whether caused by a US recession or not, will be about liquidity, not solvency – just like its predecessor, and the one before that. We do not see the financial system as secularly challenged.
In this context, taking avoiding action might prove premature, and costly. If you’re invested already in a diversified, balanced portfolio, best to sit tight. If not, we’d still advise taking advantage of any setbacks to climb aboard.
The current cycle: lessons from 2015
Among other things, we were reminded that emerging markets remain relatively risky, and that commodities are not that scarce. We saw the Greek government’s bluff called by its euro partners. But a particularly important lesson (re)learned in 2015 was the importance of not being dogmatic about interest rates and bond yields.
Yet again, expectations of higher interest rates were postponed for much of the year as the Federal Reserve (Fed) and Bank of England held fire (figure 1). Meanwhile, the European Central Bank (ECB), Swiss National Bank (SNB), Bank of Japan and People’s Bank of China actively loosened monetary policy. Allowing for exchange rate movements, local monetary conditions tightened in the US, and were not as loose as they seemed in Switzerland and China – but overall, the monetary climate was more lenient than we’d expected.
Low inflation – thanks to oil prices and still-subdued pay – and China’s slowdown helped explain the postponement at the Fed. That said, higher US rates now seem imminent as we write, and it’s unlikely to be a case of “one and done”. We expect the Fed to start a long process of normalising rates, with the Bank of England eventually starting to follow in 2016.
We continue to doubt that the initial moves will have a lasting impact on stock markets. Increasingly, we wonder whether even bonds will be quite as hurt as we might have thought a year or two back. With central banks owning a big part of the global market, and little hint of an upturn in core inflation even as headline rates rebound in the New Year, bonds may not sell-off dramatically. When some inflation does arrive, history shows it can take yields a long time to respond – even when central banks haven’t been buying bonds.
We’ve expected US policy rates to start to normalize at some stage because we think US economic growth can continue, even though we’re now in the seventh year of expansion. With America’s private sector – consumers and businesses together – still running a cashflow surplus, and effectively supplying liquidity to the rest of the economy, there is plenty of fuel still in the tank, and some modest inflation risk.
Meanwhile, those low oil prices are boosting developed consumers’ spending power, and the fading of fiscal austerity removes a further headwind. Cyclical indicators point to trend-like growth in most big economies (figure 2). Even China is showing little sign of collapse (whether you believe the official targets for growth or not).
Trend economic growth, and levels of inflation and interest rates that are likely to remain historically low even in the US and UK, is not a bad investment prospect. As weak oil company earnings move into the rear-view mirror, total profits can stay resilient, leaving stock market valuations unremarkable (figures 3 and 4).
A dramatic sell-off in bonds may be avoided, but we still doubt they offer inflation-beating returns at today’s low yields. The same is true of most investment grade corporate bonds, although they look a little less expensive after underperforming in 2015. High-yield (or speculative grade bonds) probably now offer inflation-beating returns as yields have risen, but not yet compellingly so. We continue to advise that the best prospects for multi-year inflation-beating returns come from stocks (with the US and continental Europe currently most favoured on a top-down, “macro” view, and the UK, developed Asia ex-Japan and emerging markets least).
We are not rash enough to predict one-year market returns – even knowing that US stocks have tended to do relatively well in Presidential election years (they are supposed to fare even better in the previous year). If pushed, we’d suggest referring again to the four possible profits/valuations scenarios (figure 5). We suggested a year ago that in 2015 valuations might stay the same, but earnings would grow – consistent with a position on the borderline of the “best of both worlds” and “nervous reflation” scenarios, in blue market territory. The outcome was an oil-related fall in earnings, but higher trailing valuations, with market returns currently (just) in blue territory in the “benefit of the doubt” quadrant.
For 2016, earnings might rebound as the oil effect fades, but trailing PEs could fall back, as the “benefit of the doubt” is called-in. This places us somewhere in the “nervous reflation” scenario. We suspect that investor relief at 2015’s feared risks not materialising may push us into the blue segment – but it could be another close call.
Exchange rate conviction has to remain low, and we do not advise trading currencies (or routinely hedging equity positions). On a one-year view, we’d continue to rank the majors in descending order of attractiveness as dollar, sterling, yen, euro, Swiss franc and yuan. Higher US interest rates should be priced in, but the US’ underlying strength may still not be – and the dollar is not yet especially expensive (figure 6).
The next crisis?
Like the business cycle, more severe financial crises may be unavoidable – not because capitalism is fundamentally flawed, but because consumers, managers and investors are prone to contagious, extrapolative moods of (irrational) exuberance and despondency.
Suppressing such waves entirely might stifle growth and innovation. And sheltering in cash can be damaging to investors’ long-term real wealth, because the clear message from history is that however shocking they are at the time, their long-term impact has been swamped by routine, ongoing growth.
A financial crisis threatens the financial infrastructure, which since 1971 has been built wholly on paper (or electronic) monetary foundations. The absence of a more tangible form of money has made many commentators wary. But all money, whether backed by metal, paper or bytes, is ultimately founded on confidence. And while some forms might be more vulnerable than others, the gold standard epoch was not always noted for stability.
In 2008’s Global Financial Crisis (GFC), many asserted that the system was insolvent. However, while individuals, companies and banks can be insolvent – and very traumatically so – the same can’t be meaningfully true of the system as a whole. The GFC was about aggregate liquidity, not solvency, as are most crises.
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