It has been nearly 10 years since the worst of the financial crisis, and some investors may be wondering when the next big threat will materialize, especially since the U.S. stock market is in its longest bull market ever and currently trading at, or near, records.
According to Charles Schwab, there is both good news and bad news on this front. The good news is the global economy is better positioned, through regulation and technological advances, to protect itself against many of the kind of shocks that have historically risen to wreak havoc on share prices. The bad news is there are issues that could grow into crises at a time when the economy may be unusually vulnerable to one taking hold, and at a time when there are limited tools to combat such a scenario.
“The system is often at its most vulnerable near the end of the global economic cycle when excesses have built up and managing risks may have been neglected,” wrote Jeffrey Kleintop, Schwab’s chief global investment strategist, in research note dated Monday.
While Kleintop didn’t explicitly forecast a near-term crisis, he did express concern about global debt levels. This, he suggested could be both be the cause of a crisis, by resulting in a surge of inflation or higher interest rates, for example, or a factor that makes a crisis deeper and longer lasting by limiting the ability of institutions to combat an economic shock.
Citing data from the International Monetary Fund, Kleintop wrote that global debt stood at $164 trillion at the end of 2016, the most recent period for which data are available. That represents 225% of global GDP, and growth of $50 trillion from pre-financial-crisis levels.
As that chart demonstrates, the majority of that growth came from emerging and developing economies, the fallout of which was recently seen in Turkey, where high levels of debt — along with political instability and steep inflation — has sparked a crisis that decimated its currency and stock market, leading to concerns about contagion into other regions.
Over the coming years, the U.S. could be the primary leader of growing debt, as the country is “the only advanced economy that will see a further increase in debt-to-GDP ratio over the next five years,” Kleintop wrote, again citing IMF data.
Courtesy Charles Schwab
“While a high debt burden isn’t necessarily a problem by itself, it increases the vulnerability of the system to a shock—in particular, a shock that would lift interest rates,” Kleintop wrote. “In theory, all that debt means the potential losses from a rise in interest rates would be more costly than in the past, especially combined with a stronger dollar pushing up the cost of dollar-denominated debt outside the United States.”
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The interconnectedness of the global economy means that if one region starts to undergo a crisis, the ramifications could ripple globally. According to Schwab, which cited data from FactSet, global stocks are heavily dependent on global trade. For the stocks that make up the MSCI world index, 55% of their revenue is derived from outside their home country. (For the U.S. SPX, +0.21% , it is below 40%.)
No matter what the cause of the next crisis, Kleintop suggested political instability could make the issue worse.
Among recent developments, the U.K. is struggling to exit from the European Union and other countries are finding it difficult to form stable governments. Partisanship is running high in the U.S., meaning it could be difficult to pass legislation designed to address a major economic problem. On top of that, President Donald Trump has been unsettling longstanding global partnerships by criticizing major international allies on issues related to trade, while questioning the U.S.’s leadership role in the North Atlantic Treaty Organization.
The result of all this, Schwab’s analyst warned, “may be that the willingness or ability of governments to mount an effective response to a shock is impaired and could lead to a crisis.”
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Even if governments were to agree on solutions, however, there may not be many effective options for them to choose from. Kleintop noted that interest rates are low or even negative around the world, eliminating rate cuts as a tool, and that central-bank balance sheets have swollen over the past decade, which could give them less flexibility to engage in another round of quantitative easing. In the U.S., the rising budget deficit could make it more difficult to pass stimulative spending measures.
“While a downturn that could require as much stimulus as the financial crisis is unlikely, the vulnerability posed by limited ammunition to fight a downturn could lengthen and deepen the effects of the shock,” he wrote.
Kleintop’s view isn’t entirely negative. He noted that inflation is “low and well contained” in major economies, that companies are sitting on big cash cushions, and that changes to stock exchanges — such as the institution of “circuit breakers” — would help limit the risk of a single-day crash.
On a more granular level, he wrote that the economy had become far more efficient in how it uses crude oil, meaning that a supply disruption wouldn’t have the kind of economic impact of decades ago, and that banks are much stronger than they were during the financial crisis or European debt crisis.
Perhaps most notably for investors, Kleintop said global stock valuations “are above average, as is typical after an extended period of growth, but not at extremes or as broadly above average as they were in 2000.”
Less extreme valuations, he said, limited the risk of a shock.
Courtesy Charles Schwab
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