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.1 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.2
“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.3
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.4 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.
1 International Monetary Fund data as of 4/2018.
2 FactSet data as of 8/19/2018.
3 Bloomberg data as of 8/19/2018.
4 “Passive Market Share to Overtake Active in the U.S. No Later than 2024,” Moody’s Investors Service, 2/2/2017.