What Could Cause a Financial Collapse?
Famous economist Nouriel Roubini has recently has made a bold call that a global recession and financial collapse is fast approaching.
In an op-ed in the Financial Times, he said, “Yet by 2020, there are several reasons why conditions for a global recession and financial crisis may emerge.” (Source: “Is the next financial crisis already brewing?,” Financial Times, September 11, 2018.)
Why could 2020 be the year when a global recession and financial collapse emerge, and not this year or the next?
According to Roubini, “The global expansion is likely to continue this year and next because the US is running large fiscal deficits, China is continuing stimulative policies and Europe remains on a recovery path.” (Source: Ibid.)
What could cause the next financial crisis and global recession? Roubini offered three main reasons:
- A U.S.-China trade war and trade friction between the U.S. and Europe and NAFTA countries. Roubini argues that U.S. policies will ultimately lead to higher inflation and slower growth.
- Asset prices: “Most are frothy,” he says. Stock valuations are extremely above historical averages, credit is expensive, real estate is dull globally, and emerging market asset prices are already in correction.
- President Donald Trump. The president is attacking the Federal Reserve at a time when the U.S. is witnessing robust economic growth (gross domestic product grounded at four percent). What will he do when the U.S. economy is growing at one percent in 2020?
Roubini Correctly Predicted 2008 Crisis Well in Advance
Should we give any attention to what the man nicknamed “Dr. Doom” is saying? Put simply, yes.
Nouriel Roubini is well recognized for his work, so his warning regarding a global recession and financial crisis shouldn’t be taken lightly. He is one of the few economists who predicted the financial crisis of 2008 correctly, and he could be right this time around as well.
In September 2006, Roubini gave a speech in front of economists at the International Monetary Fund (IMF), saying that the U.S. economy will face a once-in-a-lifetime housing bust, plummeting consumer confidence, an oil shock, and a deep recession.
At that time, he wasn’t taken seriously—he was even laughed at. After Roubini’s speech, the moderator said, “I think perhaps we will need a stiff drink after that.” (Source: “Dr. Doom.” The New York Times, August 15, 2018.)
Our Analysis: Could Global Recession, Financial Crisis Really Occur by 2020?
We side with Nouriel Roubini on his call for mayhem in the financial system, and for a global recession. We believe the odds of a recession and financial collapse are stacking higher each day.
Understand that the U.S. is the largest economy in the world, while China is the second-largest. What do you think will happen if two of the biggest economies in the world collide with each other on trade? It will have consequences on a global scale.
Companies will suffer. All of a sudden, they could find themselves stuck and not able to do business the same way they used to. Take Caterpillar Inc. (NYSE:CAT), for example. It could find itself in a lot of trouble if a trade war with China escalates.
Mind you, these two biggest nations getting into a trade war will impact other economies as well. Don’t forget that the Trump administration has been using very tough rhetoric with countries like Canada and several European nations. Imagine what happens if that rhetoric turns into a full-out trade war.
Asset Prices Are Scarily High
Valuations are extremely high; Roubini is right about that.
When examining valuations of the stock market, look at the cyclically adjusted price-earnings (CAPE) ratio. It’s the price-earnings ratio adjusted for inflation and cyclicality. At the time of this writing, the CAPE ratio stood at 33.18. (Source: “U.S. Stock Markets 1871-Present and CAPE Ratio,” Yale University, last accessed September 12, 2018.)
The historical average of the CAPE ratio since 1818 is around 16.9. So, one could say that U.S. stock markets are trading 96% above their historical average.
Bonds are in scary territory, too. Interest rates, bonds’ biggest enemy, are going higher and higher. Bond investors are already getting nervous, even regarding high-quality bonds. Low-quality, high-yield bonds could face even more scrutiny.
Just look at the chart below to get some perspective. It plots the yields on five-year U.S. bonds. Remember that when yields go up, it means bond prices are going down.
In July 2016, the yield on five-year U.S. bonds was around one percent. Now it is at 2.87%, meaning an increase of 187% in just two years.
Chart courtesy of StockCharts.com
The Federal Reserve and other central banks are raising interest rates. Therefore, home values—highly correlated with interest rates—could also be highly impacted.
Emerging markets are facing scrutiny, and more of the same could follow. A lot of money went into emerging economies after the financial crisis because they were offering higher yields. Interest rates in the developed economies were low, so investors could borrow and lend in emerging economies.
With interest rates going higher in the developed world, a lot of money could be headed back, which would increase problems in the emerging markets. And don’t forget that asset prices declining could cause a financial crisis and a global recession in no time.
Donald Trump
President Trump has been very vocal about the Federal Reserve since he took office, questioning what it’s doing.
“I’m not thrilled with his raising of interest rates, no. I’m not thrilled,” he said not too long ago. (Source: “Exclusive: Trump demands Fed help on economy, complains about interest rate rises,” Reuters, August 20, 2018.)
This is happening when the U.S. economy is growing at over four percent.
If the Fed doesn’t take any action, it risks a lot of capital misallocation and soaring inflation.
And if it listens to President Trump, there could be dire consequences.
Keep in mind that if there’s a financial crisis and a global recession, the Fed won’t have many tools to support the economy.
What the Next Global Recession and Financial Crisis Could Do
I am not shocked by what Nouriel Roubini is saying. If you are a regular reader of Lombardi Letter, you will know that we have written about this several times. We may be among the minority to do so, given how complacent and optimistic the mainstream media has become.
Here’s the thing: I believe the next financial crisis and global recession could be much bigger than the last one. This time around, there’s too much debt and leverage. And while these two things may be great when things are going well, they create a lot more trouble when times are bad.
If there’s a financial collapse and global recession by 2020, don’t be shocked to see the stock market tumble way more than it did back in 2008–2009. A massive destruction of wealth could be ahead.
Don’t be alarmed to also see a major bank go bankrupt or seek a bailout. What’s more, the financial system is so interconnected that one bank going bankrupt could rattle the whole system.
Governments could end up scrambling. They have borrowed a lot of money already and may need more to remain afloat and boost their respective economies. However, when investor confidence is dull, governments may not get the money they need.
Be very careful. Sure, the last decade was great for investors, but the coming few years may not be.