Thursday, March 3, 2016

How The Next Financial Crisis Could Spread..........

How The Next Financial Crisis Could Spread

The next global financial crisis could start with U.S. stocks.

The first trigger: The strong U.S. dollar crimps U.S. exports and foreign earnings. Emerging-market weakness affects businesses in the technology, aerospace, automobile, consumer products, and luxury product industries. Currency devaluations combined with excess capacity, driven by debt-fueled over-investment in China, maintain deflationary pressures, which reduces pricing power. Lower oil prices negatively impact earnings, cash flow, and asset values of energy producers.

In turn, earnings and liquidity pressures reduce merger activity and stock buybacks, which have supported equity values. U.S. stocks tumble, and their weakness infects global equity markets.

The second trigger: Debt markets. Heavily indebted energy companies and emerging market borrowers face increased financial risk. Initially, the focus will center on the U.S. shale oil and gas industry, which is highly leveraged with borrowings that are over three-times gross operating profits.

A third trigger: Changes in liquidity conditions as the world enters a period of asynchronous monetary policy.

The Federal Reserve is scaling back, having terminated purchases of government bonds and mortgage backed securities, which at their peak provided more than $1 trillion a year in new funds to markets.

The importance of dollar liquidity is driven by the large amount of foreign currency debt, especially that issued by emerging market borrowers, which is denominated in U.S. dollars. According to the Bank of International Settlements, U.S. dollar credit to non-bank borrowers outside the U.S. totaled over $9 trillion in debt securities and bank loans — more than 50% greater since the end of 2009.

Tightening of available dollar liquidity, coupled with a stronger U.S. dollar, would result in losses on these borrowings. The risk is exacerbated by the economic distress of many emerging markets. Low commodity prices also compound the problems. It reduces the U.S. dollar-denominated revenue available to meet debt obligations of exporters, increasing potential exposures to currency fluctuations.

Global dollar liquidity is also affected by altered capital flows. Since the first oil shock, petrodollar recycling — the surplus revenues from oil exporters — has been an essential component of global capital flows, providing financing, boosting asset prices, and keeping interest rates low. A prolonged period of low oil prices will reduce petrodollar liquidity and may necessitate sales of foreign investments.

Emerging market foreign currency reserves are also falling, led by substantial falls in Chinese reserves due to a combination of weakened trading conditions, capital flight, and the suspected liquidation to release capital to support the domestic economy and equity markets.

A fourth trigger: weakness in global economic activity.

Look no further than the energy sector. The belief that lower oil prices will lead to an increase in growth may be misplaced, with the problems of producers offsetting the benefits for consumers. Around $1 trillion of new investment may not make economic sense at lower oil prices. When combined with the reduction in planned investment in other resource sectors as a result of lower prices, the adverse effect on economies will be significant. Moreover, currency volatility will place pressure on growth.

The increasing problems in emerging markets will also take a toll. Emerging-markets growth is slowing as a result of sluggish demand from developed markets, unsustainable debt, and unaddressed structural weaknesses. For commodity-producing nations in particular, lower revenues will lead to a rerating. The problems will spread across emerging markets.

Fifth, slowing growth, low inflation, and widespread financial problems will refocus attention on the level and sustainability of sovereign debt. The unresolved public debt issues of Japan and the U.S., for example, will attract renewed investor scrutiny. In Europe, the sovereign debt problems will affect core nations such as Italy and France.

A sixth and final trigger: Investors will critically appraise government and central bank policies and find them wanting. The artificial financial stability engineered by low interest-rates and QE is undermined by concern about the long-term effects of the policies and the lack of self-sustaining recovery.

The cascade of financial woes would result rapidly in a worldwide financial crisis. !!!!

The position is eerily similar to 1997-98, when falling commodity prices, especially oil, a stronger U.S. dollar, rising U.S. interest rates, and emerging-market debt weaknesses led to the Asian monetary crisis, the Russian default, and the collapse of hedge fund Long Term Capital Management. This time around the outcomes will be much worse, involving much larger sums and solutions will be very hard or impossible to find.

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