Two Catalysts That Could Trigger the Next Financial Crisis Lombardi Letter 2017-09-07 02:14:53 causes of financial crisisupcoming financial crisisvix indexlow volatilitynext financial crisisfinancial crisis 2017high leveragemarket volatility Global strategists for both JPMorgan and Citibank worry that current stock prices could lead to the next financial crisis if things materialize as expected. News,U.S. Economy https://www.lombardiletter.com/wp-content/uploads/2017/08/financial-crisis-1-150x150.jpg

Two Catalysts That Could Trigger the Next Financial Crisis

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Analysts Believe Earnings Deceleration And Rising Interest Rates Could Spark the Next Financial Crisis

Global strategists for both JPMorgan Chase & Co. (NYSE:JPM) and Citibank are concerned about stock prices. Their concerns lie in different areas, but both could lead to the same result. That is, the next financial crisis, if things materialize as expected.

The Citigroup analyst pointed to rising rates as a major threat. For a two-week period in early July 2017, there’s been a surprising burst in sovereign bond yields. Benchmark 10-year Treasury bond rates have spiked about 2.12% on June 26 to 2.37%. The Federal Reserve suddenly put the brakes on more rate hike expectations. Citi believes stocks could be “at risk” if global growth slows due to higher rates. Said the Citi analyst, “Monetary tightening could be a threat if central banks are perceived to have got ahead of the curve.” (Source: “Two catalysts that could trigger a stock market correction,” CNBC, July 10, 2017.)

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Meanwhile, JPMorgan analysts believe an earnings slowdown could be problematic for stocks. While the second quarter of 2017 should be fine, the “[Second half] is where the problems could materialize in earnest.” Particularly when it comes to earnings growth expectations, currently between seven percent to eight percent in Q3, and 12% to 15% for Q4. That’s quite ambitious considering earnings have essentially gone nowhere since 2012. Adding credence to those concerns, slowing producer price inflation is signaling the earnings slowdown to come. (Source: Ibid.)

High Levels of Leverage And Low Volatility Could Bring About the Next Financial Crisis 

Sadly for market bulls, the future causes of the next financial crisis don’t stop there. High levels of leverage and low volatility will add fuel to the fire.

Looking at the latter, the VIX Index—an options market indicator that indicates expected volatility by averaging the weighted prices of puts (bearish) and calls (bullish) over a range of strike prices—has plummeted to all-time lows. This tells us that investors are historically complacent about perceived fear in the market. This is counter-intuitive considering how far the market has run, and how many existential risks surround us. The proverbial “wall of worry” the size of Mount Everest has been scaled. But the comedown from those dizzying heights will be no laughing matter.

Recently, the VIX traded at an 8-handle for the first time ever. This unconcern has suppressed selling and allowed the market to rally for 272 days without a small correction in the S&P 500 (defined as the market avoiding losses of least five percent). Only three other rallies have lasted longer: October 5, 1992–January 31, 1994 (330 days), December 9, 1994–February 13, 1996 (296 days), and November 16, 1988–January 3, 1990 (284 days). If the exchange is able to finish August unscathed, it will be the second-largest rally without a small loss in history.

As history clearly shows, an upcoming financial crisis will only occur once fear enters the market. This would be reflected in the VIX Index. A high VIX is not necessarily bearish, but in today’s context, it is. Selling volatility to boost program buying in underlying stocks is probably the most crowded trade on Wall Street. History shows these extremely low levels will eventually break. Investors on the wrong side of the move could experience a world of pain.

financial crisis

Excessive leverage is another prime risk factor as well. Not just record-high margin debt, which has propelled stocks higher. Consumers and corporations have done the same thing. The former is saddled with record debt from consumer durables, with service payments only kept in check through record-low interest rates. Corporations have piled on debt to fund share buybacks or competitor acquisitions. Even Fed Vice Chairman Stanley Fischer stated as much. “The corporate business sector appears to be notably leveraged, with the current aggregate corporate-sector leverage standing near 20-year highs.” (Source: “Excessive Leverage Is Now The Biggest Problem Facing Markets,” ValueWalk, June 29, 2017.)

We may skirt financial crisis 2017 because the approaching recession is not quite ripe, but investors need to focus on 2018. Unless those much-anticipated Trump tax cuts and foreign capital repatriation takes effect, the factors described above will take their toll. Nobody will want to own equities if there’s the slightest whiff of recession approaching.

It’s a very simple formula. A very expensive market and crashing earnings don’t mix. Picture a cat in a swimming pool. And like that comparison, there’ll be a lot of screeching when the next financial crisis happens.

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