Eight Reasons a Financial Crisis is Coming

It's been about 10 years since the last financial crisis. FocusEconomics wants to know if another one is due.

The short answer is yes.

In the last 10 years not a single fundamental economic flaw has been fixed in the US, Europe, Japan, or China.

The Fed was behind the curve for years contributing to the bubble. Massive rounds of QE in the US, EU, and Japan created extreme equity and junk bond bubbles.

Trump's tariffs are ill-founded as is Congressional spending wasted on war.

Potential Catalysts

  1. Junk Bond Bubble Bursting
  2. Equity Bubble Bursting
  3. Italy
  4. Tariffs
  5. Brexit
  6. Pensions
  7. Housing
  8. China

Many will blame the Fed. The Fed is surely to blame, but it is prior bubble-blowing policy, not rate hikes now that are the problem.

1. Junk Bonds

Many have labeled this an "everything bubble" which is not quite accurate. Yes, the Fed re-blew the housing bubble as well as an equity bubble. But the real standout is the bubble in junk bonds.

Companies are borrowing money to buy back shares at absurd valuations.

In the US, close to 15% of the companies in the S&P 500 only survive because they can roll over their debt. For discussion, please see Rise of the Zombie Corporations: Percentage Keeps Increasing, BIS Explains Why.

I expect a junk bond crash and that will take equities lower with it.

2. Equity Bubbles

Stock valuations are stretched almost beyond belief. The CAPE - Shiller PE was only surpassed by the DotCom bubble. The CAPE PE on October 3 when I last wrote about it was 33.49.​

Meanwhile, Companies are Furiously Guide Earnings Estimates Lower.

There will be few places to hide. GMO Forecasts US Equity Losses for 7 Years.

We may not see a "crash" per se, but if not, then expect a slow bleed over many years, Japanese style.

In many ways, especially pension-related, a slow bleed will be worse than a crash. In a crash, there is often a sharp rebound, and one can use leverage. In a slowing declining setup, long leverage gets crushed.

3. Italy

Italy is Openly Defiant of Eurozone Stability Pact, Deliberately and Knowingly.

The ECB's policy of "One Size Fits Germany" does not work now and never did.

The IMF says Italy has a currency that is 9% too high. Germany has a currency that is 11% too low. Since both are on the Euro, no matter what the ECB does, it is going to exacerbate one side of the problem or the other.

Meanwhile, Target2 imbalances mount.

Italy owes creditors nearly 500 billion euros, mostly to Germany. It is impossible for Italy to repay that debt.

In an unprecedented move, EU Rebukes Italy's Budget: Italy Politely Says Screw You.

An Italy Eurozone exit looms. It will be accompanied by a currency crash.

4. Tariffs

Trump believes "trade wars are good and easy to win". Smoot-Hawley strongly suggests otherwise.

In a letter to Trump, the Committee to Unleash Prosperity seeks zero tariffs. There were several notable letter signers.

Steve Forbes, Arthur Laffer, Fred Smith, and Stephen Moore on the Committee to Unleash Prosperity ask Trump to seize the high ground and give U.S. firms an advantage.

I discussed the letter in Forbes, Laffer ask Trump for Zero tariffs, Zero Subsidies, and Zero Barriers.

Tariffs are a tax on consumers and importers of usable goods such as steel. If China is subsidizing steel it is to the benefit of US manufacturers who use steel as well as consumers who pay lower prices for goods.

It is absolutely correct to reduce tariffs, regardless of what other nations do, on that basis alone.

Trump's tariffs are staring to bite. Many US manufacturers are already complaining. Unfortunately, Trump is just getting started.

5. Brexit

Short-term, a hard Brexit will be bad all around. But long-term it will be bad only for the EU.

The German export machine depends on the UK far more than the other way around. Under a WTO, hard Brexit scenario, German exports are likely to crash. That will happen at a time when German de-industrialization is already underway dues to a shift to electric and self-driving vehicles.

Surplus countries get killed in these scenarios.

For discussion, please see Inevitable De-Industrialization of Europe.

European demographics are also exceptionally poor. Even a "soft Brexit" will be bad for Europe.

6. Pensions

US public pensions are woefully underfunded despite the historic ris in the stock market.

When the crash or prolonged slowdown happens, boomers expecting pension payments either will not get them, or there will be massive tax hikes.

Both options are economic poison.

7. Housing

It should now be pretty clear that housing has peaked this cycle: Existing Home Sales Drop 6th Consecutive Month

Yet, the Fed still has four more rate hikes penciled in.

I doubt those hikes happen. Regardless, a key economic driver is already on the skids.

8. China

China's State Owned Enterprises (SOEs) are in huge financial trouble as is China's export machine coinciding with Trump tariffs.

In 2007 conventional wisdom was that China would decouple from the global economy. It didn't, as I stated well before the bust.

Today, conventional wisdom is the US will decouple from the global economy.

It won't. Trump's tariffs will exacerbate problems in China and the US.

What's the Catalyst?

All of the above. Alternatively, none of the above.

It does not matter what the catalyst is actually. And there might not be any catalyst other than simple exhaustion: The pool of greater fools in stocks, bonds, and housing simply ran out.

Regardless, I expect all eight of the above discussion points to be in play when the crisis does hit.

Who Will Take the Blame?

A Recession is Coming. Who Will Take the blame?

Of course, nobody will volunteer to take any portion of the blame.

Yet, fingers will be pointing.

  • Trump will blame the Fed for hiking too fast.
  • The Fed will blame Trump for starting a trade war.

Scarcely anyone will blame fractional reserve lending, lack of a gold standard, Congressional stupidity, or central bank cheap money and their bubble blowing tactics.

It is a given that mainstream media will not remotely come close to pointing a finger in the proper direction.

Mentioned Articles In Order of Appearance

Buy gold. A financial crisis, not just a recession, is on the horizon.

Mike "Mish" Shedlock

Comments (34)
No. 1-19
Sechel
Sechel

I would say the big reason is how we deal with risk. We have a couple of choices, arm the regulators and make regulatory risk the #1 and not economic growth, put real teeth in the ability of the buy-side to sue when they've been harmed by deceit and have tax payers and the government stop subsidizing risk taken on by our financial institutions. We've really not done any of this.

Examples when brokers, etc pitch investments they are often held to a suitability vs a fiduciary standard. This isn't because the public wants this, its because the industry has lobbied for it, Banks getting out of the volcker rule and the end of glass-Steagall, Government limiting class action lawsuits against banks, Too big to fail banks still around and the knowledge the Fed will bail them out, which means they can borrow in the capital markets at below market risk spreads. There are more examples

Realist
Realist

A good summary of risks. Certainly a crash/recession is always possible. As always, timing is the issue. I lean more towards slowing growth in economies and markets. As I have mentioned before, 2% growth for the next few year in the US, followed by average 1% growth over the next few decades. Markets are unpredictable and volatile due to the preponderance of short term thinking, but I still expect modest appreciation over the next few decades.

KidHorn
KidHorn

And we'll have a split legislative branch that will be paralyzed to do anything. The house will vote to impeach Trump, the senate won't. And that's the only thing that will happen in 2019-2020.

ReadyKilowatt
ReadyKilowatt

And after the crash there will be calls to restrict stock buybacks because the corporations didn't do what they were supposed to do with the low interest money the fed put out on the street. "We're going to keep doing this until you get it right!"

Sechel
Sechel

i'd say a financial crisis is happening because brokers and banks treat customers as counter-parties and not customers they owe a fiduciary responsibility to, that we still don't have transparency in financial products such as swap trading on exchanges, banks that still get subsidized by the government and engage in risky activities that serve no social purpose yet get the benefit of access to the fed and fdic insurance and customers who when they get ripped off are unable to sue, borrowers of student loans who can never void the debt because banks have used their lobbying clout to rewrite the bankruptcy laws.

shamrock
shamrock

The trailing P/e ratio is 22. Moreover, I've seen analysis that if you remove the FAANG stocks the P/E ratio of the remaining 495 stocks is about 20% lower. So, a P/E ratio around 18 really isn't that high.

Carl_R
Carl_R

The PE ratio is a function of three things. Those three things are the interest rate, the market risk premium (stocks are riskier than bonds, and should provide a higher expected return), and the expected growth rate. If inflation rises, the interest rate will follow, driving down the PE ratio. If the growth rate declines, that will also drive down the PE ratio.

What Realist doesn't seem to realize is that, in the scenario he describes in his post below, with the growth rate declining from 4% to 1%, the result will not be that stocks appreciate at 1% rather than 4%. Rather, in times of increasing growth rate, stocks appreciate much faster than growth (as we have just experienced) because the PE expands while earnings expand. Conversely, in times when the growth rate is falling, even though earnings continue to rise, the PE contracts, and stocks fall even as earnings rise. If the overall economic growth rate falls to 1% from 4%, as Realist predicts, that will cause the PE rate to drop by 1/3. A 33% decline in the PE ratio over 10 years implies a stock market that falls 3% a year for a decade. If interest rates return to historical norms, the decline will be even greater.

The point Mish may miss is that the CAPE PE ratio is not independent of other factors. The current PE of 34 is not an inexplicable bubble. The high PE right now is to be expected because the interest rate is low, and the growth rate is high. While it is true that the CAPE PE typically falls back to historical norms over time, it doesn't get there via random behavior. Interest rates will not remain low forever, and GDP growth will not remain at 4% forever. As interest rates rise, and as the economic growth rate falls, the PE ratio will behave in a normal fashion and fall as well.

So long as interest remains low, and growth remains high, the current stock prices can continue to rise. Mish seems to believe rates will remain low, and that is quite possible, and if they remain low, it will continue to support high stock prices. On the other hand, continued growth at 4% seems unlikely, and if it drops to the 2.5% range, that will take about 15% off the market.

WCVarones
WCVarones

Why you say "forward P/E" when referring to CAPE? That's a backward P/E.

hmk
hmk

The real solution is to strip the fed of all of its mandates and delegate their only function to being the lender of last resort to prevent a liquidity crisis. They have no business setting interest rates or anything else based on their "theoretical models" they learned about in their ivory towers. Recessions, crashes ,and depression self clear a lot quicker without those idiots at the fed trying to help their Manhatten friends get richer. The free market will clear any the detritus resulting from the crash quite well on its own and a lot quicker. This happened in 1923 as an example. James Grant wrote a book about it.

Mike Mish Shedlock
Mike Mish Shedlock

Editor

Yes, I should have said CAPE PE - Thanks

Blacklisted
Blacklisted

Wrong again. The 8 reasons you sight are all the result of govt largess, and the UNWILLINGNESS of govt to go on a diet, which is "forcing" them to get increasingly totalitarian in going after other peoples money. This is the driver behind the anti-establishment movements around the world ... and it will get worse.

The source of the economic reset will be a rising dollar and rising rates, which will impact the rest of the world first. Sadly to say, their career politicians are more corrupt and favor Marxist policies more than ours.

To say "Congressional stupidity" is partially to blame is like saying Jeffrey Dahmer had an eating disorder. It's not stupidity if you intentionally deceive, and commit fraud and corruption to line your own pockets. If you want to place blame, look no further than the career politician. Short term-limits is the necessary first step for real reforms.

caradoc-again
caradoc-again

When it begins to really hurt expect some sort of debt jubilee else the debt will be a weight around global economy's neck for very many years. Recovery will take ages otherwise.

With a jubilee other changes will occur.

I just wonder who/how to be on the right side of it. Possibly through gold but I don't trust tptb not to somehow find a way to limit gold repricing upwards.

RB2
RB2

Of course the Fed is to blame coming and going. AND Alan G blew up the dot coms as much as AOL did with a pe of 400.

REMant
REMant

It can't possibly be good for Germany and China to be subsidizing their exports. Tariffs aren't the problem; easy money is.

prichards
prichards

Crashes are systemic and the ONLY outcome every time.

rum_runner
rum_runner

When was it that you called the top, Mish? 2014?

killben
killben

"It is a given that mainstream media will not remotely come close to pointing a finger in the proper direction."

Yup! They will be busy yelling for the Powell put. The wall street cry babies have already started wailing even though NOTHING MUCH HAS HAPPENED... (

These guys just love to gorge on the money that simply flows from the Fed's teats. Birds of the same feather flock together. Scoundrels!

Irondoor
Irondoor

I vote for "Congressional stupidity". The root of all stupid laws.

shred1
shred1

Mish, you seein' double? Some double posts of paragraphs in your article. The Fed is to blame.