What Will Trigger the Next Crisis?
Potential threats include bad loans, a euro exodus, China’s debt levels, earthquakes
Illustration: Peter Oumanski (4)
The person who predicts the next financial crisis, and there will be at least one, should get credit for luck rather than forecasting skill. A decade of extraordinarily low interest rates has created multiple distortions in the global economy and financial system. Any of those can unwind painfully but predicting what factors would trigger a global downturn is near impossible. Five columnists from Heard on the Street give it a try.
Interest Rates Jump
The biggest distortion in global markets is also the most important. Rock-bottom interest rates, driven by central banks to allow economies to heal, have encouraged risk-taking. Barring a downturn, interest rates will rise in most of the world, and rising interest rates always expose cracks in the financial system.
That was clear in February when a slight uptick in U.S. inflation expectations sent rates higher and ultimately caused the implosion of a multibillion-dollar fund that bet against market volatility.
Higher rates have typically pushed down stocks and commodities. In a crisis scenario, that would be just the beginning. The losses could be magnified by leverage and lead to higher defaults on public and private corporate debt, which could trigger capital flight and currency depreciations in emerging markets. The result would be an economic slowdown that could make each of these problems worse.
Interest rates globally have never been this low for this long. A sustained increase puts the global financial system in uncharted territory.
—Aaron Back
Bad-Loan Boom
The flip side to low interest rates has been a chase for yield that has driven investors to embrace riskier bonds. The result has been a boom in corporate borrowing and a race to the bottom both for high-quality and junk-rated companies. This drop in credit quality means that when the economy slows, losses are likely to be worse than in previous downturns.
Companies rated BBB, the lowest investment-grade rating, now account for almost half of all U.S. investment-grade corporate bonds by value, the highest share in more than 15 years. Among high-yield borrowers in bond and loan markets, new issuance from companies rated at the lowest B grade also make up a record share of new volume.
That raises the risk of significant losses for credit investors—from pension funds and insurers to mutual funds, ETFs and banks. The downturn could be made worse because banks are less able to trade debt than in the past, leaving some investors unable to sell their holdings.
—Paul J. Davies
Italy Dumps the Euro
The recovery of the eurozone from the 2012 bond crisis has been predicated on Italy, Spain and Portugal pledging to meet the European Union’s budget rules, and Germany overlooking the fact they haven’t. As long as countries stick with the project, markets have rightly ignored debts and deficits.
But Italy may be wavering. Italian bond yields spiked in May after two parties with anti-euro leanings tried to form a new government. The crisis could escalate again once politicians return from holidays. Some 59% of Italians want to keep the common currency, official surveys show—the slimmest majority in the eurozone.
If Italy left the euro, Italian banks would face runs on their deposits and would be crushed—sovereign debt accounts for 9% of their assets.// This would paralyze lending and the economy. The shock waves would ripple abroad: Foreigners own 36% of Italian government debt. Markets would lose faith in Spain and Portugal’s debt and eurozone banks outside of Italy, which own $140 billion of Italian debt. This would weigh on the eurozone, one of the world’s three main economic engines.
—Jon Sindreu
China Cracks
China and the U.S. are the two other big global economies. When external demand weakens, China pumps up investment at home, as it did in 2009. Its growth has been powered in part by one of the fastest buildups of debt in history by a major country. That would worsen any financial crisis at home.
China has so far weathered the dual threats of trade war and a rising dollar well. The most likely causes for a China-triggered global crisis would be a real-estate crash or rolling defaults by local government-owned fundraising vehicles, severely damaging bank balance sheets, tanking investment and driving big capital outflows.
Abroad, a weakening of China’s economic might would drive down prices for commodities and the value of many emerging-market currencies, prompting widespread dollar-bond defaults which could damage Western lenders. Chinese capital fleeing the country would sharply drive up the dollar. Slower emerging market growth would hit U.S. and European exporters.
—Nathaniel Taplin
Supply-Chain Disruptions
Catastrophe can strike at any moment—and quickly reverberate. Decades of globalization and technological progress have made it easy for the fallout of natural or man-made disasters to become global.
Consider a handful of isolated events with outsize impact. In 2011, flooding in Thailand slowed the global supply chain for personal computers as makers of hard drives were shut down. Last year, a computer virus crippled the fleet of AP Moeller-Maersk ,the world’s largest container shipping firm. The 2011 earthquake and tsunami in Japan caused auto plants world-wide to shut down as key components became unavailable. In 2010, the eruption of an Icelandic volcano caused the cancellation of over 100,000 flights, affecting about 10 million passengers.
And in 2016, a construction accident cut off a third of the U.S. East Coast’s gasoline and jet-fuel supply, sparking price spikes and shortages.
Unpredictable weather and rogue nations could do far worse, enough to bankrupt major companies or spark a recession.
—Spencer Jakab
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