How Could the Next Market Crash Occur?Trevor Gerszt
Business cycles are funny things. No one realizes that the top of the market has been reached until months after the decline has already started. And no one realizes the bottom has been reached until months into the recovery. That’s why so many financial advisers recommend against trying to time markets. You just can’t ever tell for sure whether the next big drop in markets is a momentary blip or the start of a trend, or whether the next big rally is the beginning of a recovery or just a bit of misplaced hope.
In 2007 everyone saw that the housing market was starting to show signs of trouble, but no one thought that subprime mortgages were going to be a huge problem. Had you told someone in mid-2007 that Bear Stearns and Lehman Brothers would both cease to exist within a little over a year, you probably would have been met with uproarious laughter. Yet that was exactly what took place.
None of the officials at the Fed, no one within the government, and very few within Wall Street understood what was going on with the economy back then, which is why so many people were caught completely unprepared by what ended up happening in 2008. This time around it seems that many more people are wary of the economy, still remembering the financial crisis and its effects, and trying to prepare and protect themselves against a market crash. But how will that crash take place?
In 2007 things started with a unit of Bear Stearns that started experiencing difficulty. As more and more subprime loans started to go bad and firms exposed to those loans started to experience problems, Wall Street began to get really nervous. By September 2008 capital markets had nearly frozen and the Treasury Department was warning of a complete collapse of the financial system. Will we see a redux of that scenario in the coming years?
Trade War With China
The trade war with China has once again become front and center in the mind of markets. With President Trump now having placed tariffs on all Chinese imports, China responding by devaluing the yuan, and the US countering by labeling China a currency manipulator, we may now be entering a new era of international trade.
The past several decades have seen the US economy becoming more and more reliant on China, with numerous US companies outsourcing production to China or sourcing raw materials from China. Now that trade between the US and China is slowing significantly, many of those companies may very well have to start finding new partners in other countries or start sourcing their materials elsewhere. Those who invested most heavily in China will face huge hits to their bottom line, and all companies are now facing the prospect of having to offer significantly more expensive products.
There’s no doubt that the trade war will weigh heavily on most companies, and will cost US consumers too. But no one knows for sure what the effects will be two, three, or five years down the road. Will the trade war with China precipitate an economic crisis? Probably not, but there’s no doubt that it will exacerbate any crisis that will occur.
Headlines earlier this year were full of apocalyptic warnings about the future of US agriculture. Massive amounts of rain throughout the Midwest drowned early plantings, and waterlogged soil kept many farmers from being able to plant corn until late in the season, if at all. The corn harvest for 2019 is expected to be the worst in 40 years, and many farmers affected by the spring flooding may end up having to declare bankruptcy.
Combine that with the collapse in the soybean market as the result of China’s decision to place tariffs on and then stop purchases of US agricultural products, and you have a recipe for most farmers in the Midwest to find themselves under significant financial pressure. This fall could end up seeing a wave of bankruptcies and defaults as farmers struggle to sell what little they were able to grow this year.
Many who live in cities take it for granted that food shows up in their grocery stores and don’t think about where that food actually comes from. They also don’t understand the importance of farms to regional economies in states like Kansas, Iowa, Nebraska, and others. If a significant number of farms end up going bankrupt, that could lead to defaults on loans, plummeting prices for agricultural land, and knock-on effects throughout the financial system. With so many Midwestern banks involved in loaning money to farms, farm bankruptcies could result in many regional banks going out of business too.
Will that be the cause of the next crisis? Again, it’s hard to think of that as the main driver of the next financial crisis, but there’s no doubt that anything negative that happens to farmers will have spillover effects on the rest of the economy.
Mountains of Debt
A decade since the end of the financial crisis, Americans are more indebted than ever. Whether it’s student debt, auto loans, or corporate debt, there has been a veritable debt explosion in this country. That was the natural result of nearly a decade of near zero interest rates.
With interest rates as low as they were, corporations naturally sought to take advantage of those low borrowing costs. Corporate debt issuance has exploded while, at the same time, corporate debt ratings have plummeted. There are trillions more dollars of corporate debt circulating today, with much of it near junk status. In fact, it’s probably the corporate bond bubble bursting that will start off the next crisis. But how will that happen?
With the Federal Reserve attempting to force interest rates down again by cutting its target federal funds rate, we’ll have to see how markets react. Will market interest rates begin decoupling from the prime rate at some point as the spread between the prime rate and market rates begins to climb? And what would cause that decoupling?
It’s not inconceivable that a downgrade to a major corporation could spur massive upheaval in bond markets. With so many pension funds investing in investment-grade bonds, downgrading those bonds to junk (BB+ or lower) would in many cases trigger automatic sales of those bonds. There are some big names in the BBB arena, including General Motors, GE, Ford, Verizon, and Kraft Heinz.
Downgrades to one or more corporations and the ensuing bond sales could lead to frozen capital markets and a repeat of what we saw in 2008. With the trillions of dollars the Fed pumped into the financial system through quantitative easing still in the system, how will the Fed react? Will we see more quantitative easing, more lending facilities and more bailouts?
We also can’t forget about mortgage risk, as subprime lending is returning. Non-bank lenders are growing at rates that we haven’t seen since the last housing bubble, and in many cases they’re borrowing money from mainstream banks, putting those banks at risk if the non-bank lenders end up failing. There’s just so much debt out there right now that a default anywhere could provide the impetus for the next crash.
With so much instability in markets right now, investors need to protect themselves against the growing likelihood of a catastrophic collapse in markets. We’re entering the last stages of the boom phase, with the bust just around the corner. That’s one reason gold has shot up in price recently, as investors realize that the economy is about to fall off a cliff, so they’re rushing to invest in gold.
Once the crash begins in earnest, there will be a rush for the exits as investors look to offload their stock holdings to anyone who will take them and look to buy gold. Don’t be left holding the bag when that happens, make the move today to protect your portfolio and safeguard your retirement assets.