Central banks unwinding quantitative easing, potential crises in China and Italy, elevated global trade imbalances and a backdrop of populism: Just some of the potential sources of the next financial crisis, according to the latest research from Deutsche Bank.
In a report looking for the potential source of the next financial shock, Deutsche Bank strategists Jim Reid, Nick Burns, Sukanto Chanda and Craig Nicol warned that there are "a number of areas of the global financial system that look at extreme levels."
"This includes valuations in many asset classes, the incredibly unique size of central bank balance sheets, debt levels, multi-century all-time lows in interest rates and even the level of potentially game changing populist political support around the globe. If there is a crisis relatively soon (within the next 2-3 years), it would be hard to look at these variables and say that there was no way of spotting them."
Although the strategists note that their list of potential sources for the next financial shock is "far from a prediction that they will occur," their list is designed to show where some of the stresses are in the financial system and ones that could create global financial and economic problems.
Here's what Deutsche Bank is worried about:
Central banks including the Federal Reserve, European Central Bank and Bank of England are embarking on what has been called the "Great Unwind" – the winding-down of quantitative easing programs which included trillions of dollars' worth of asset purchases and record low interest rates that have bolstered economies, financial markets and banking systems.
Calling the "Great Unwind" a "journey into the unknown," the strategists warned that "history would suggest there will be substantial consequences of the move especially given the elevated level of many global asset prices" adding that "even if the unwind stalls as either central banks get cold feet or if the economy unexpectedly weakens, we will still be left with an unprecedented global situation and one which makes finance inherently unstable."
The strategists said there was a danger that central banks and governments could find themselves without ammunition to tackle a recession should one occur, given their already near zero interest rates, creaking balance sheets, and a backdrop of high levels of government debt.
"Could the next recession be the one where policy makers are the most impotent they've been for 45 years or will they simply go for even more extreme tactics and resort to full on monetization to pay for a fiscal splurge? It does feel that we're at a crossroads and the next downturn could be marked by extreme events given the policy cul-de-sac we seem to be nearing the end of," Reid et al warned.
Since the financial crisis of ten years ago, persistently low inflation has been a constant headache for central banks, the Deutsche Bank strategists noted, a situation they found "fairly incredible" given the phenomenal level of central bank and government stimulus.
"Although not our base case, given the recent inflation and Trump's fiscal challenges, it's not infeasible that markets could be blindsided by a return to more QE rather than less…If central banks do end up conducting increased QE again, the risk is we again go back to negative rates and worries about the banking system and the plumbing of the financial system."
Turning to the euro zone's third largest economy, Deutsche Bank's strategists warned of more political and economic uncertainty from Italy.
"A country nearing an election and with high populist party support, with a generationally underperforming economy, a comparatively huge debt burden, and a fragile banking system which continues to have to deal with legacy toxic debt holdings ticks a number of boxes to us for the ingredients of a potential next financial crisis."
Conceding that China's economy had so far avoided a hard landing predicted by many economists, Deutsche Bank warned that China still needed to transition its economy "from manufacturing to services and investment to consumption," a process with Deutsche Bank said "needs to take place in the context of also containing the rapid growth of credit in our view."
"Rapid credit expansion due to an insatiable demand for debt fuelled growth, compounded by a hugely active shadow banking system, as well as an ever expanding property bubble fuelled fears for economists that China could inevitably make a hard landing and send shockwaves through the world's financial markets. However, the economy has seemingly defied the odds."
"However, future growth cannot forever rely on debt and investment alone…The warning signs are there and the fundamental vulnerabilities remain. The greater issue might be 'when' rather than 'if' the credit bubble pops."
Deutsche Bank's strategists noted that the current financial system is much more crisis prone due to "huge cross border flows" and global current account imbalances. These imbalances, derived from trade, imports and exports mean that some countries having a current account surplus - an excess of savings over investment – and others a deficit – an excess of investment over savings which can make them vulnerable to global capital flows (namely, outflows) and meaning domestic policy makers have less control of their own economies, the strategists noted.
"If an investor in one country believes that country A is a good place to invest, it's likely that other investors in other countries will also share that view. As such flows are very often travelling in the same direction. The reciprocal to this is also true," but they warn that "if sentiment changes in the global financial system, flows can reverse at the touch of a button and the current global landscape makes this more possible."
Noting that populism has "exploded across the globe" with the election of Donald Trump as U.S. president, the vote for Brexit and the rise of the anti-establishment vote in France (with the far-right National Front's Marine Le Pen reaching the last stages of France's election earlier this year), Deutsche Bank predict populist political parties will continue to pose a threat to established political parties.
"While the consequence of the recent rise in populism hasn't yet destabilised financial markets, the level of uncertainty will surely remain high while such parties remain realistic power brokers in major national elections."
Deutsche Bank noted that "we're in a period of very elevated global asset prices – possibly the most elevated in aggregate through history."
"While there are no obvious triggers for historically high global asset valuations to correct, while they remain this high there is always a risk of a sudden correction that could be destabilizing to a financial system and global economy that seems to require such elevated asset prices."
Despite the government's attempts to boost the economy and inflation with its so-called 'Abenomics' (named after Japanese Prime Minister Shinzo Abe) plan of monetary easing, fiscal stimulus and structural reforms over the last five years, Deutsche Bank noted that Japan continues to face a financial and demographic problem.
"Japan continues to face the challenge of trying to manage large budget deficits, large QE and the highest public debt ratio in the developed world at a time when the population is falling and ageing, with obviously fewer and fewer workers to pay the bills and more and more elderly to try to support."
"Stubbornly low inflation hasn't disappeared despite the odd green shoot emerging and growth, while showing some signs of stabilising, in absolute terms continues to make slow progress. All of these issues make Japan a still very relevant story."
The U.K.'s process to leave the European Union (EU) also factors in Deutsche Bank's list of possible financial shocks, although the strategists note that, as negotiations between the U.K. and EU about a future relationship are in an early stage, "Brexit is a complicated issue with many potential outcomes over the years ahead."
"Ultimately our expectation is that compromise will be reached and the U.K. and EU will establish a new relationship. However in this uncertain world the vote to leave in June 2016 throws up a potential crisis if negotiations completely break down. Through most of history, we tend to think compromise is always the most likely outcome when such differences exist and where there is the chance of mutually assured destruction. The extreme example being World War II when no-one really expected war, weeks and months before it arrived. How spectacularly wrong that assumption was. So it's worth highlighting how Brexit could go wrong and create a financial crisis," they note.
Lastly, Deutsche's strategists list the decline in market liquidity as a potential crunch point, were inflows into emerging market and developed market bond funds to dramatically reverse.
"Fixed income seems the most vulnerable as it's the market that has seen a combination of large inflows, huge growth and reduced market making activity… Whilst this is not automatically a worry it would argue that if there was a change in the yield environment and returns suffered, bond funds would arguably be vulnerable to these 'return chasing' momentum flows," Deustche argued. "If this occurred at the same time as central banks started to reverse their substantial purchases it could lead to a sharp correction in prices that could encourage or exacerbate a crisis," Deutsche Bank warned.