The forthcoming global crisis

by Alasdair Macleod, GoldMoney:

The global economy is now in an expansionary phase, with bank credit being increasingly available for non-financial borrowers. This is always the prelude to the crisis phase of the credit cycle.

Most national economies are directly boosted by China, the important exception being America. This is confirmed by dollar weakness, which is expected to continue. The likely trigger for the crisis will be from the Eurozone, where the shift in monetary policy and the collapse in bond prices will be greatest. Importantly, we can put a tentative date on the crisis phase in the middle to second half of 2018, or early 2019 at the latest.

Introduction

Ever since the last credit crisis in 2007/8, the next crisis has been anticipated by investors. First, it was the inflationary consequences of zero interest rates and quantitative easing, morphing into negative rates in the Eurozone and Japan. Extreme monetary policies surely indicated an economic and financial crisis was just waiting to happen. Then the Eurozone started a series of crises, the first of several Greek ones, the Cyprus bail-in, then Spain, Portugal and Italy. Any of these could have collapsed the world’s financial order.

But Mario Draghi steadied the sinking Eurozone banking system by promising to do whatever it takes. We derided him, but he has succeeded. The intention of zero interest rates and QE was to prevent a slide into deflation, a spiral of collapsing bank credit and asset values. Markets steadied. It was intended to restore private sector wealth by inflating asset prices. It enriched the hard-pressed financial sector, with bond and stock markets not only recovering, but going on to record levels. A sense of wealth has returned to the portfolio-owning classes. The DAX has risen over 225% and the S&P 500 nearly 250%. Inflation, by which commentators mean the rate of increase in consumer prices, has not yet reflected the massive injection of monetary inflation from the time of the crisis. At least, not on official CPI figures.

If there is a lesson for us all since the great financial crisis, it is that central banks, even though dealt an appalling hand, are very good at managing local systemic problems, real or imagined. Bearish hedge fund managers, those masters of the universe, are throwing in the towel. Valuations, according to their models, cannot be explained, let alone justified.

In truth, these investors have made the same mistake every cycle. They see the bubbles, but fail to fully understand their source. They think bubbles are solely the result of the madness of crowds, irrational bullishness ignoring fundamentals. They fail to dig a little deeper and understand the source is a repeating credit cycle. Only when you understand that financial bubbles are merely visible symptoms, can you begin to understand the underlying disease.

The global credit cycle is in a new expansionary phase, which can be expected to change market characteristics. Only now are we sufficiently advanced in the global credit cycle to speculate about its evolution into crisis. This article takes the reader through the likely manifestations of it, providing a road map for reference of its progress, and where and when it is likely to hit first.


Credit cycle recap

During a credit crisis, the expansion of the money quantity at the behest of the central bank is aimed at saving the banks. Otherwise, banks, which are highly-leveraged financially, would simply collapse under a combination of their customers’ bad debts and falling collateral values.

Assuming monetary policy rescues the banks from the crisis, the financial system becomes stabilised, the crisis is over, and we move into a second phase of recovery. Unemployment starts being cyclically high, and price inflation remains subdued. The banks are still traumatised, expanding credit only to the government and their largest low-risk customers. On the back of improving bond prices, they begin to expand credit towards their own and associated financial activities, remaining cautious over lending to the medium and smaller business sectors (SMEs), which between them form the bulk of non-financial economic activity. This recovery from the crisis is prolonged by government intervention, which generally seeks to prevent malinvestments being liquidated, freeing up capital to be used more productively.

As time goes on, the banks begin to grow confident that the crisis has passed, and memories of it fade. They gradually extend their lending to SMEs, which represents the silent majority of the non-financial economy. We have now entered the expansionary third phase, where banks increasingly compete for what they have now decided is low-risk business. The second half of the expansionary phase is characterised by low unemployment, growing skill shortages, and rising price inflation. Rising prices cheapen the real interest rate to a lower level than in the recovery phase, upsetting the balance between the expansion of credit and availability of capital and consumption goods even more. It is this that eventually forces the central bank to raise interest rates to the point where the next crisis phase is upon us. Central banks have no option but to address the falling purchasing power of the currency by raising interest rates sufficiently to stabilise it.

A debt crisis is triggered, because business models are undermined by rising financing costs. Companies collapse. In addition, the legacy of accumulated debt means high interest rates undermine the credit status of long-term debts and the asset values dependant on them, particularly of property. Government welfare costs rise and state finances deteriorate rapidly. As financial intermediaries, the banks are caught in the middle of the crisis, and being operationally geared, face bankruptcy. There comes that moment when even ordinary people wonder if they have lost everything.

That is why having triggered the crisis, central banks then rapidly change course and do everything, however financially unsound, to ensure the financial system survives and governments can continue to be financed.

Every credit cycle evolves on this approximate framework, but each has its specific characteristics. Progression from one phase to the other is often difficult to detect, and sometimes only obvious long after the event. But the repetition of crisis, recovery, expansion and crisis again is the structure of every credit cycle.

Over recent credit cycles, the magnitude of the crisis phase has increased, reflecting the enormous debt burden accumulating in the overall global economy. Since the financial reforms of the 1980s, there has been a new and growing element in the advanced economies: the expansion of credit aimed at financing consumption, which has now overtaken the application of credit aimed at production. This does not change the cycle framework, but it does alter its characteristics and visibility.


Global expansion is already here

The G20’s efforts to coordinate monetary policy globally have been undoubtedly successful. Unfortunately, they make credit expansion a truly international phenomenon, eventually feeding into a synchronised global credit cycle. International coordination of monetary policy increases the economic and price distortions for everyone, rolling up several smaller waves into one big tsunami. Furthermore, when the crisis hits one jurisdiction, the chances today are higher than before it will be transmitted to the others. So, we must consider this as a global experience, likely to be triggered from anywhere.

Investors based in Western capital markets often point the finger at China. We know that China’s massive credit expansion of recent years has already taken her into an expansionary phase. All the signs are there in plain sight, because the government is working to a predetermined published plan. The current five-year plan is intended to make China, in partnership with Russia, the dominant economic force on the Eurasian continent.

China is the most significant contributor to the current global credit expansion phase, benefiting all those that trade with her. Britain, a trading partner, has also been at full employment for some time. She has an open service-based economy, which permits it to expand in the direction of maximum opportunity. She is in the vanguard of providing services, technology and manufactured goods to China, and for all the other countries in Asia that are expanding with her. Germany is also expanding on the back of the Chinese story, but in her case principally as a supplier of capital goods. Japan, whose mighty corporations have factories throughout East Asia, is also doing well.

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