While we should enjoy good financial markets while they last, we should also look around the corner at possible risk factors, particularly systemic risks. If a system is unstable, any number of triggers could cause the financial system to unravel, precipitating a recession or depression. This article summarizes five sources of systemic instability:
1. High Debt
Global debt has increased at an accelerating rate to $277 trillion, some 364% of global GDP1, higher than any time since World War II. The quality of debt has diminished, with percentage of total debt denominated as junk increasing from 33% to 36%2 during the past year alone; during the pandemic this trend is likely to continue.
High debt levels are inherently unstable—diminishing resiliency to absorb shocks and increasing likelihood of default in case of interruption or diminution of revenues.
2. Stock valuations are at historic highs, interest rates at historic lows
Warren Buffet’s favorite indicator is the Market Capitalization to GDP ratio. Currently, the US ratio is 72% over its historic average, higher than ever before, including before the 2008 crash3. Most other metrics, like Price/Earnings ratios, CAPE ratio, etc. are also frothy. Historic highs have typically been followed by crashes and multi-year periods where investor returns were low. Today investors have reason be skittish, and may well opt to divest on signs of weakness and lock in gains.
There is a case that low interest rates may actually justify astronomic valuations. But what if interest rates start rising, say due to resurging inflation? Many Governments and corporations would default, creating a wave of bankruptcies, triggering a recession or depression.
3. Central Banks as a source of instability
Central banks have been buying massive amounts of bonds, driving interest rates down. Hence investors must invest in higher risk securities in order to achieve yield objectives. Lower interest rates encourage greater risk taking (higher debt levels, lower debt quality, etc.).
When the next crisis comes, to right the ship, far greater amounts of stimulus will be need than ever before. While stimulus will provide short-term relief, even the IMF admits “policymakers must weigh the pros of more stimulus today against the cons of higher financial stability risks in the future.4”
The Fed owns an ever larger share of treasuries. Other investors are becoming increasingly reluctant to invest in a treasury market so dominated by the Fed, constraining the Government’s future policy options. Financing the deficit may become increasingly linked to printing money, potentially resulting in loss of confidence, weakening of the USD, inflation, etc.
4. Triffin Dilemma
Given that the US Dollar is the global reserve currency, the US must constantly furnish the global financial system with dollars, hence the US must consistently run a trade deficit. No matter how many “deals” Trump tried to strike to reduce the trade deficit, the US deficit only grew further.
Economists have been writing for decades about the Triffin paradox, and the resulting instabilities in the global financial system. Forty or fifty years ago, when the US accounted for 40% of global GDP5, 70% of world trade was in US dollars, and the US was the world’s largest importer — the US had the wherewithal to maintain the system. Fast forward to today, the US share of global GDP diminished to 24%6, only 37% of global payments are in USD (with the Euro catching up rapidly at 33%)7. As US dominance of the global economy diminishes, so too does the US ability to maintain global reserve currency status for the USD8.
The weakness of the dollar as a reserve currency is a global risk, because “treasuries are the biggest component of most countries’ foreign-exchange reserves.9” Many countries are now attempting to diversify their reserves away from USD, which in turn risks accelerating the decline.
Warren Buffet has famously called derivatives “weapons of mass destruction”. During the 2008 crisis, according to the Financial Crisis Inquiry Commission, “the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic…10”
In 2016, the IMF concluded that Deutsche Bank’s links to other financial institutions, as related to derivatives, posed a greater risk to global financial stability than any other bank. In 2018 DB still had $43 trillion of derivatives!
In a nutshell, there are many instabilities. Each of the five instabilities described above have the potential not only to degenerate into vicious circles, but also to fortify each other, creating a perfect storm. According to Didier Sornette, an ETF Professor, the collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary. Unfortunately, after a crash, the debate tends to focus on why no one saw the trigger.