From Charles Schwab & Co.
With the 10-year anniversary of the onset of the global financial crisis just weeks away, now is a good time to ask where the next global economic crisis might come from. To be clear: We’re not sounding any alarms here. We don’t think a crisis is imminent. But we do like to keep our eyes on the horizon.
Reforms to the global financial system in the wake of the 2008–2009 crisis mean the next crisis probably won’t look like the last one. So what will it look like?
“If you follow the financial news, then you know shocks to the global system happen all the time — and are promptly absorbed by the system without much disruption,” says Schwab chief global investment strategist Jeffrey Kleintop. “Some recent examples could include the recent tensions between the U.S. and North Korea, the U.S. Fed beginning to reverse its quantitative easing program or the rapid unwinding of the short-volatility trade that took place earlier this year.”
“More concerning are shocks that could have a deeper impact,” he says. “That happens when a shock hits the system and the system isn’t prepared for it. 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.”
Since we may now be in the later stages of a cycle, let’s review some of the potential sources of vulnerability out there. Here are five:
High debt levels
Since 2001, global debt has nearly tripled. As of 2016 — the latest year for which International Monetary Fund data is available — global debt stood at $164 trillion (225% of gross domestic product), up from $62 trillion in 2001 and $116 trillion in 2007, just ahead of the onset of the financial crisis. More than a third of developed economies have debt-to-GDP ratios above 85%, according to the IMF. That’s three times worse than 2000.
“While a high debt burden by itself isn’t necessarily a cause for concern, it increases the vulnerability to rising interest rates, particularly with quantitative easing programs — which kept interest rates low — winding down,” says Jeff. “Throw in a strong dollar pushing up the cost of dollar-denominated debt overseas, and the shock from rising interest rates could be costly.”
Of course, some of that global debt is held by central banks, Jeff says, so they may not face the kind of pressure that companies or commercial banks face.
One side effect of the global financial crisis has been a general loss of faith in the political establishment across the major economies. Populism — of both the left- and right-wing varieties — has been on the rise, posing a challenge to governments’ abilities to make decisions, or in some cases form governments at all. As a result, governments may be unwilling — or unable — to mount an effective response to a potential economic or financial shock.
Dependence on international trade
Companies increasingly rely on global markets to sell their goods. For example, the companies that make up the global stock market — as represented by the MSCI World Index — now earn more than half of their revenue overseas, according to FactSet.
“Even domestic sales can be impacted by shocks to increasingly interconnected global supply chains,” Jeff says. “That means many global companies are more vulnerable to shocks from bottlenecks or border issues than in the past.”
Less ammunition to fight a downturn
Although a downturn requiring as much stimulus as was required in 2008 is unlikely, were it needed, governments today have much less leeway to increase public spending or ease monetary policy than they had a decade ago. Blame it on rising budget deficits, still-low interest rates and bloated balance sheets. In the U.S., the projected budget deficit for 2018 is $804 billion (4.5% of GDP), up from its 2007 pre-crisis level of $161 billion (1.1% of GDP). And the combined balance sheets of the U.S. Federal Reserve, the European Central Bank and the Bank of Japan have spiraled from roughly $3.5 trillion at the beginning of 2008 to nearly $15 trillion today.
The rise of passive investing
Passive management has taken the investing world by storm. Whether that could be a source of risk remains to be seen. At the very least, the rise of passive investing represents a major change. How much of a change? Moody’s Investors Service forecasts that sometime between 2021 and 2024, more than half of U.S. investor assets will be invested in passively managed strategies — overtaking the share of assets in actively managed strategies. That’s quite a change from 2006 when just 15% of investor assets were invested in passive strategies.
“Some fear that passive investing’s mechanical approach could give rise to distortions in the pricing of individual securities,” says Jeff, “potentially reducing diversification while amplifying the impact of investors’ trading patterns on the overall market when a large number of buyers or sellers act simultaneously.”
Preparing for the next one
It is impossible to say when the next crisis might hit or what it will look like. So what’s an investor to do?
Diversification is key: Make sure your investments are spread across a variety of asset classes, and review your asset allocation regularly to make sure it’s consistent with your time horizon and risk tolerance. Remember that if you’re a long-term investor, shorter-term market fluctuations should not be of particular concern. But if today’s vulnerabilities make you queasy, perhaps it’s a good time to talk with someone about your portfolio.
Lawton Retirement Plan Consultants, LLC (LRPC) Monday Morning Minute is crafted to provide decision-makers with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly $475 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or firstname.lastname@example.org or visit the firm’s website at http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges, and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.
Additional Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Investing involves risk including loss of principal. International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. Diversification does not ensure a profit and do not protect against losses in declining markets. The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results. The MSCI World Index captures large and mid-cap representation across 23 Developed Markets countries. With 1,643 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.