Three Hard Truths About The Next Financial Crisis

Three Hard Truths About The Next Financial Crisis
Stéphane Renevier, CFA

over 1 year ago7 mins

  • Speculative bubbles have popped, cracks have started to appear in the global financial system, and it all raises the chance that we’ll experience a financial crisis.

  • But the hard truth is that we’ve got no clue what will cause it, when it will hit, and how bad it will be.

  • That doesn’t mean you can’t do anything about it, mind you: make sure you’re prepared to handle extreme market scenarios, both psychologically and financially, and keep some cash on hand for opportunities that arise.

Speculative bubbles have popped, cracks have started to appear in the global financial system, and it all raises the chance that we’ll experience a financial crisis.

But the hard truth is that we’ve got no clue what will cause it, when it will hit, and how bad it will be.

That doesn’t mean you can’t do anything about it, mind you: make sure you’re prepared to handle extreme market scenarios, both psychologically and financially, and keep some cash on hand for opportunities that arise.

Mentioned in story

Global financial crises aren’t your traditional recession: they add extreme stress not just to asset prices, but also to the whole financial system. When they happen, markets stop functioning properly and the resulting fear triggers some of the sharpest losses. Now, with cracks starting to appear in some parts of the system, people are wondering whether we are heading that way. So here are a few things you should know about financial crises, including three hard truths...

What could cause the next financial crisis?

Global financial crises aren’t created by a single factor. Sure, they often do start with a small problem in a dark corner of the market (like subprime mortgages in 2008), but it takes the burst of a serious bubble (like housing markets in 2008) and the presence of several reinforcing factors (like high leverage, hidden risks in financial products, and deep links between different parties) for the world’s financial system to begin to buckle.

The global financial system has evolved a lot since 2008, so it’s unlikely that the next crisis will be driven by the same factors (although real estate might play a role again). There will likely be new drivers, and these are likely to be a few of them:

Private markets

Markets like real estate, venture capital, private debt, and private equity have seen the biggest excesses over recent years, and so they provide a fertile hunting ground for where things could go wrong. Since many of these vehicles are illiquid, highly leveraged, complex, and opaque, they may prove particularly fragile if volatility rises and investors are forced to sell.

Asset managers

Since the 2008-09 global financial crisis, they’ve replaced banks as the “master of the universe”, and have ventured into ever more complex strategies and products. And it’s not just hedge funds: the biggest asset managers have launched loads of ETFs – some exotic, some highly levered, some illiquid, and many with the same investment rules – which could create issues if investors all run for the exit at once. And as the IMF recently warned, even “safe” instruments like open-ended bond funds – which hold a fifth of all financial assets held outside of banks – could pose a threat to market stability.

Fixed-income markets

Debt markets could be the trouble spot again, but in a new way – maybe arising from the shattering of some complex interest rates derivatives product or from a total collapse of liquidity in bond markets. Or, perhaps more likely, the sharply rising dollar could eventually lead to a wave of sovereign defaults, as we explained here.

Self-reinforcing factors

In the aftermath of the 2008-09 global financial crisis, tons of new regulations were adopted to try to curb the reinforcing factors that exacerbated the system’s fall. But plenty still exist. For example, banks’ chanciest activities are now performed by other intermediaries (like hedge funds), which may mean that the systematic risk has simply moved to other areas. And with banks no longer performing the role of traditional intermediary, that's made market liquidity – the ability to quickly purchase an asset – a lot patchier and more unpredictable. And derivatives, despite being more restricted, still present some risks – it’s still hard to know who’s on the other side of those trades. Finally, many participants still have a mismatch between their assets and liabilities, like borrowing in the short term but lending in the long term, or borrowing a “safe” asset to buy a risky one, or borrowing in another currency. Those mismatches tend to lead to forced selling when market conditions worsen, as the recent failure of liability-driven investment (LDI) strategies illustrated.

There are other potential points for risk too –clearinghouses, the places where financial institutions complete transactions, could fail; or cyberattacks could happen. A recent report from the European Systemic Risk Board identifies a laundry list of risks it deems of greatest threat to financial stability.

But here’s the first hard truth: no one knows what’ll spark the next financial crisis. In the same way that (almost) no one expected that pension funds could be so close to blowing up the UK financial system last month, no one really knows which market or product could start a global chain reaction. If we knew, the crisis probably wouldn’t happen.

When is it likely to happen?

As the late German economist Rüdiger Dornbush famously said: “the crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”

Timing when a bubble will pop isn’t the only hard part. Knowing when things will go from a normal downturn to a full-blown financial crisis is the other one. Take the global financial crisis: the first signs of trouble started to appear at the beginning of 2007 but it was only in early 2008 that investors started to worry that issues with the housing market would spread to the economy and the financial system. And while it took months for the S&P 500 to lose the first 25%, it took it less than two weeks for it to fall another 20%. Prices then recovered 20% before collapsing another 25%, and didn’t find a bottom until March 2009. And even then, investors still didn’t know whether the recovery had truly begun.

The bubble of highly speculative assets has already popped, stocks are already in a bear market, and a strong dollar, liquidity issues in Treasury markets, stress in the UK financial system, and sky-high costs of protecting against defaults of European banks are all adding to market troubles. So it’s fair to say that if a financial crisis is indeed on the way, it could arrive sooner, rather than later.

So here’s the second hard truth: no one knows exactly when the next financial crisis will hit. We can make guesses, but it’s almost certain to take us by surprise. Financial crises are not subtle things: even if the next one arrives within your timeframe, prices might move so fast that it’ll be extremely hard to make money from it.

How bad will it be?

Hopefully not as bad as the last one: after all, banks are more heavily regulated, derivatives markets are under closer supervision, leverage in the system is lower, and institutions, governments, and central banks have all learned important lessons from previous crises. And it’s not just theoretical: this “new-look” financial system largely held its own during the Covid crash.

Thing is, before every financial crisis, people thought that there’d been ample guardrails in place. But every time, something unexpected happened and exposed the system’s blind spots. As we highlighted earlier, many things could go wrong in many markets. Add to that an energy crisis, the biggest inflation shock in a half-century, and the potential for a new world war, and you have to accept the third hard truth: we’ve got no clue how bad the next crisis will be.

What should you do then?

You should start by accepting the fact that the things we don’t know outnumber the things we do know when it comes to the next financial crisis. But even if we don’t know what will cause it, when it will hit, and how bad it will be, we do know that stubbornly high inflation and a strong labor market are forcing the Federal Reserve to raise interest rates at its fastest pace ever, and that cracks have started to appear in the global financial system. This doesn’t mean a financial crisis is a certainty, but it significantly raises the probability of something going very wrong. Put more simply, it means you can hope for the best, but prepare for the worst.

So focus on what you can control, and make sure your portfolio can survive what you can’t control. That means avoiding using leverage, and making sure you can psychologically and financially handle large losses and extreme uncertainty. If you don’t think you can handle a loss larger than 50%, you should probably reduce your risk. Now more than ever, make sure the money you have in markets is money you can afford to lose.

It’s also a good idea to keep some cash on hand for when opportunities arise. Because behind every big fall is an opportunity. Devise a clear game plan for when and what you’ll start buying again. If you’re not sure how, I shared some tips here.

Finally, remember that absolutely no one can forecast exactly what will happen next, so take everything you read with a pinch of salt and don’t let FOMO or panic drive your decisions. Investing is often won with your stomach, not with your brain.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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