What Will The Next Crisis Look Like?

What Will The Next Crisis Look Like?
Stéphane Renevier, CFA

over 1 year ago5 mins

  • Today’s market shares traits with previous crises: the stagflation era of the 1970s, the dotcom crash of 2000, and the global financial crisis of 2008-09.

  • The similarities between the dotcom crash and the current tech stock boom and bust suggests the Nasdaq may have quite a bit further to fall.

  • The high inflation and low growth of the 1970s are eerily familiar, and the era comes with a warning: rate hikes and slower economic growth don’t always bring inflation down.

Today’s market shares traits with previous crises: the stagflation era of the 1970s, the dotcom crash of 2000, and the global financial crisis of 2008-09.

The similarities between the dotcom crash and the current tech stock boom and bust suggests the Nasdaq may have quite a bit further to fall.

The high inflation and low growth of the 1970s are eerily familiar, and the era comes with a warning: rate hikes and slower economic growth don’t always bring inflation down.

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The S&P 500 started the week in bear territory, raising concerns about worsening market conditions, and the specter of a new crisis. But what that crisis might look like and whether it’ll resemble ones from the market’s past are a matter of debate. After all, as Mark Twain famously said, “History doesn’t repeat itself, but it often rhymes.” Here’s what the next crisis may (or may not) look like…

Which crises are most similar to the one that’s brewing now?

The dotcom crash of 2000

It’d be easy to compare today’s market conditions to the dotcom crash. The recent low interest rates and tech innovations have facilitated a boom in certain speculative assets – like disruptive tech shares, cryptocurrencies and meme stocks. We’ve seen valuations of unproven, unprofitable companies soar and ultimately deflate just like we saw two decades ago.

This wouldn’t be the worst outcome. While the dotcom crash was brutal for tech stocks – the Nasdaq fell 82% and didn’t recover for 16 years – the fallout barely nudged the actual US economy or other assets. US GDP saw a short, shallow decline, while bonds, commodities, and the housing market remained basically unchanged.

The global financial crisis of 2008-09

This sprawling economic crisis was preceded by a “great moderation”, essentially, a period of economic growth, stability and low inflation. And, in that respect, that’s not unlike today.

However, that previous stability set the conditions for the ensuing crash: easy access to financing, and a can’t-lose approach to risky assets. Cheap credit facilitated the use of significant leverage while financial engineering hid the true risks brewing under the surface. So when the unthinkable happened – i.e. real-estate prices started to fall – the whole house of cards collapsed. And with banks at the center of the storm, the risks quickly spread to other sectors. The crisis caused enormous economic pain: GDP collapsed at its fastest pace since the 1930’s, the financial system froze, and entire sectors came to a halt.

The 1970s stagflation crisis

Now the previous two crises also were preceded by higher oil prices and somewhat hotter inflation, but nothing compared to what went down in the ‘70s, when the Fed was forced to aggressively hike interest rates to try to tame double-digit inflation. In that sense, today’s environment looks eerily similar to that period.

What followed in the 1970s was disastrous: the economy fell twice into a recession over that period, first in 1973 and again in 1980. But the worst was the realization that slower economic growth doesn’t always bring inflation down.

So, which crisis is most likely to repeat itself?

A repeat of the dotcom crash is a real possibility. Tech company valuations are arguably as extreme as they were back then – and with no capitulation in sight, the Nasdaq looks like it has a lot further to fall.

But this time, it seems less likely that the selloff will be limited to just the riskiest corners of the US stock market. Bond yields have experienced their most extreme moves ever, and that’s likely to impact key segments of the wider economy, from the housing market to private equity deals.

Another full-blown financial crisis, thankfully, is far less likely. Significant guard rails were put in place after the last meltdown. Plus, today, the real economy is in a much better position: consumers have a decent cash buffer and are carrying less debt. Companies are also in a better financial shape and still benefiting from record margins. The financial sector too, is better equipped to deal with a shock: banks are better capitalized and there are fewer signs of extreme leverage in the system.

Nonetheless, if the global financial crisis taught us one thing, it’s how interconnected the system is and that a big enough catalyst can bring the whole edifice down. And while banks are safer, risks may have moved to darker corners of the economy, with non-bank institutions replacing banks for many of their risk-taking activities. What’s more, while banks' liquidity has improved, the COVID crisis showed that market liquidity hasn’t. Put differently, in an extreme event, the financial system may not be as resilient as it appears, and asset prices might experience even bigger moves than before.

But the big worry is those 1970s-style headwinds. The stubbornly high inflation we have today is likely to exacerbate the recent downturn in US stocks, and complicate the recovery. Unlike during past downturns, when the Fed moved to cut interest rates to stimulate investment and job growth, the Fed isn’t likely to be much help here. It’s going to be focused on raising interest rates, to try to rein in inflation. That will tamp down growth, but as the 1970s-era recessions showed, it may not be enough to cool inflation, and we might have to live in the less-than-ideal environment of slow growth and high inflation over the next few years.

So what our little time travel has shown is that the next crisis isn't likely to mirror those from the past – it's likely to be a crisis all its own, perhaps borrowing elements from each one before it.

So, what’s the opportunity in all this?

Now, if this all sounds very pessimistic, remember: we’re talking about the next crisis. As an investor, it’s wise to hope for the best, but prepare for the worst. As we’ve said repeatedly in recent months, now is the time to be defensive with your portfolio. In stocks, favor high-quality businesses in defensive industries over risky, cyclical ones. And consider diversifying into other regions (like Europe, Japan and China) and styles (like value stocks over growth stocks).

Also, make sure you own assets that can perform well in different environments. So in addition to stocks (which perform best in high growth and low inflation) own assets like Treasury bonds (best in falling growth and inflation), gold (best in falling growth and higher inflation), and other commodities (best in rising growth and inflation). And to protect against the risk of seeing all your assets falling at the same time, you could also consider buying the US dollar.

Last but not least, make sure you keep enough cash on hand to profit from the opportunities that will arise when other investors throw in the towel and sell, as they undoubtedly will. And if you have a long-term horizon, don’t sell when things look the bleakest. As Peter Lynch said, "In the stock markets, the most important organ is the stomach. It's not the 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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