A Nightmare Scenario For Global Financial Markets

Global financial markets could face a nightmare scenario one day: the burst of multiple bubbles, fueled by years of easy money around the globe.

That’s what happened back in 2008-9. US stocks dropped 37%, German stocks 42%, and Chinese stocks 62%; commodities dropped 37 percent (with oil and copper dropping 54%). This means that investors had nowhere to hide, taking multiple hits across their portfolios.

The real causes of the 2008-9 crisis can be traced back to the September 2001 Greenspan “put,” which cut the cost of holding different assets. This means that investors didn’t have to sell one asset to buy another, as was the case before Greenspan’ put went in place. That explains why stocks, commodities, and US T-bonds rallied simultaneously between 2001 and 2007—though T-bonds usually move in the opposite direction than stocks and commodities.

The resumption of easy money policy by the Federal Reserve, ECB, and Bank of Japan in the aftermath of the 2008 financial crisis has re-affirmed and strengthened the positive correlation of different asset categories.

Once again, investors do not have to sell one asset to buy another. They can borrow at near zero interest rates, buying everything with a positive yield.

In fact, investors are in constant search for assets that look undervalued compared to other assets that are already overvalued. Like US Treasuries, which look undervalued compared to German and Japanese bonds, currently trading with negative yields.

Never mind that America is running a large government deficit, which continues to add to its already sizable national debt—running at 105.40% of GDP—see table.

Source: Tradingeconomics.com 8/23/19

Also, investors buy high yield emerging market debt and stocks with high dividend payouts because these investments are better alternatives to money sitting in a savings account.

Simply put, easy money has created multiple bubbles that have been blowing in all directions.

Meanwhile, easy money has undermined the old strategy of asset allocation, setting investors up for a nasty surprise when the bubbles burst.

"In excess of $13 trillion of global bonds have negative yields; in effect, investors are paying issuers to take cash investments,” says Iain Wilson, Advisor at NEM Ventures. “As we embark on another round of Central Bank interest rate cuts, possibly combined with more radical QE programs, we should consider the knock-on effects of ultra-low rates on asset prices. Globally, a whole range of traditional asset classes, such as stocks, bonds, property, and credit have seen huge price appreciation and history tells us that asset price booms rarely end well.”

While it’s hard to predict when the multiple bubbles will burst, it isn’t too difficult to come up with a couple of events that could set the stage for that to happen.

One such event would be another emerging market crisis that parallels the Tequila and the Asian Currency crisis back in the 1990s. It could be provoked by a sharp devaluation of emerging market economies with a large dollar denominated debt, which would fuel sovereign debt defaults.

Then there’s the potential for high profile corporate failures, which could shake-up investor confidence in publicly-traded companies -- like the Enron and MCI WorldCom failures back in early 2000.

And there’s the possibility of another high-profile Wall Street scandal. Like the Madoff scandal that was followed by the 2008-9 crash, which created a sell-off contagion.

But there’s a big difference this time around. Interest rates are much lower than the previous three cases. This means the hunt for yield is much more aggressive than before.

Meanwhile, central bankers are running out of “bullets,” ie policies to cope with the situation, as the global economy gets divided by trade and currency wars.