New crisis on the way?

financial-crisis-aheadHow the 2008 recession happened?

The 2008 crash and the Great Recession that followed have shaken the world markets and its economy. It was the biggest since the 1929 crash and the Great Depression, so its effects were significant, putting at stake both the fundaments of the financial theories and of the economic theories. The SP500 index, the main American index, decreased from 1565,15 points on 9th of October of 2007 to 676,53 on the 9th of March of 2009 – less than half. The unemployment level rose from 4,9% in February 2008 to 10,0% in October 2009 with the Per Capita GDP decreasing from 49571 dollars in 2007 to 47041 dollars in 2009. Prices also turned negative due to the economic downfall.

This crisis was a result of several factors. One of them was undoubtedly an irresponsible monetary policy by the FED keeping the interest rates too low for too long, from the Dotcom bubble in 2001 until 2004, which led to an explosion of credits, creating a housing bubble that reached unprecedented proportions. This excessive creditation was also created due to risky loans granted to “ninja” clients that had no income, no job and no assets. The theory behind it was that the CDO contracts, a security backed by an asset, usually a mortgage, the same mortgages held by the “ninja” clients. The CDO is then sliced into tranches and sold to banks all over the world. They had high ratings, often AAA, despite being composed mostly of risky assets, so there was a lot of confidence in them. However, when default rates spiked, influenced by the increase in interest rates, housing prices started to decrease sharply leading to a huge decrease in the CDO’s price and all the system collapsed leading to a severe crisis of global proportions.

Recovery

The response to this crisis in most of the countries was a clear split with the neo liberal policies endorsed in previous crises, in fact since the 70’s oil crisis. Due to the similarities with the Great Depression, the Keynesian policies were recovered, more intensely in the US than in Europe, consisting of a fiscal stimulus and an increase in public expenditure with some asset relief programs such as the TARP (Troubled Asset Relief Program) in October 2008 and in the European Union the smaller European Stimulus Plan in November 2008. However, due to the sovereign debt crisis, Europe quickly turned down these policies, applying instead austerity measures especially in Greece, Ireland, Portugal and Spain, reaching an interesting contrast between US and Europe. But perhaps the most striking change brought by this crisis was in the monetary policy. Probably that is the reason why the American economy is recovering while the European economy is stagnating. The decrease in the interest rates was huge, they reached 0%, the zero low bound, in the US and in other countries such as Japan and the UK but still they were not enough to recover the economy. So, Central Banks all over the world had to adopt new policy measures. The most famous one was the quantitative easing. It consisted in a massive purchase of assets such as mortgage backed securities and long-term government bonds by Central Banks, mostly FED, with the objective of lowering not only short term but also long term interest rates. Besides promoting economic growth and employment this aggressive monetary policy should also increase the price level approximating it to the target rate set by the Central Bank. For the ECB this is even more important because its major objective is to keep the price level close to the target rate, around 1,5%-2% and not today’s rate close to 0%. So, it’s curious why the ECB only applied the Quantitative Easing in 2014 and reached the 0% interest rate only in 2015, which might reflect a too conservative monetary policy.

Captura de ecrã 2016-01-26, às 00.04.39

Captura de ecrã 2016-01-26, às 00.05.35

Why can a crisis start?

Following the previous analysis Europe is still in a difficult situation with certain regions remaining in crisis. So, if a crisis starts, Europe would probably be one of the most affected regions. The mini-crash in 24th August 2015 revealed instability of the financial markets and a good part of that instability was caused by China. The Chinese economy is slowing down. After growth rates of 10% and more before 2011, China grew only between 7% and 8% with slower growth expected for the years to come. That’s because China is struggling to do the transition to a new economic model more based on internal demand with higher production costs than before, due to the increase in wages. That led to a sharp devaluation of the Yuan, which favors Chinese exports but strings imports or, putting it differently, European and American exports. Obviously, that would be quite negative for those economies and that paralyzed the stock markets globally because China is now the second biggest economy in the world.

Another factor is the decrease in the price of oil caused because the decrease in demand generated by the Chinese slowdown, the exploitation of the shale gas in the US and the end of the sanctions against Iran, which increase the supply. The decrease in the price of oil might benefit most the European countries that are net importers, but is negative for some companies in those countries, and especially hazardous for countries like Russia, Canada, Norway, the Gulf States and Venezuela. Another problem is that some European banks are highly exposed to oil companies that are highly affected by the sharp decline in oil and oil derivates’ prices.

There’s also the feeling in the last few months that America’s growth is slowing down.

Captura de ecrã 2016-01-26, às 00.18.08.png

In the graph above we can see that after an excellent second half of 2013 and the second, third and fourth trimester of 2014, in 2015 the economy seems to be a bit more stiff than the homologous growth in the third quarter of 2015 being 2,3 percentage points less than in 2014.The forecast for the growth rate in the fourth quarter is 1% which continues a trend of deceleration of the growth rates. However, with the expansion of the quantitative easing in the third quarter of 2015, the economy should be able to present good results in 2016.

There’s also the psychological factor created by the statements of people like the economist Nouriel Roubini, who also predicted the subprime crisis, George Soros one of the biggest and most influential investors ever, and the recommendations of the Royal Bank of Scotland, Societé Generale and JP Morgan. All these predict that a big crash will happen in 2016 in the financial markets with more or less implications for the real economy with a lot of risk in the markets predicting a decrease up until 75% of the American indexes and advising that they should seek refuge on high quality bonds. A sign of this might be the fact that the Price/Equity ratio (a ratio that measures the current share prices relative to the earnings per share) is 26, much above the equilibrium value of 15 which means that the shares might be overvalued especially when they are at the third higher value of the century, only behind 1929 and 2000, periods that were followed by the Great Depression and the Dotcom crisis.

Scenarios

To conclude and judging from all these arguments, I see two major scenarios that might happen.

One of them is a positive scenario in which the US economy continues to grow, Europe recovers and finally gets a firm and steady growth, China successfully makes the transition to an internal demand based economy and the situation in the Middle East gets stabilized, the war in Syria ends and the tensions between Iran and Saudi Arabia are reduced. The stock markets will continue to grow in the next few years with valorizations of around 10%-20% per year.

The other is a more negative scenario in which a crash will happen in 2016 or perhaps in 2017 following a period of instability in the markets. China continues slowing down, the US will start slowing down before the crash and after the crash it may enter in a recession that will bring after it other regions of the world. In Europe, the Euro Zone might be in peril, with a likely Grexit and maybe other countries like Portugal do to large public and private debts. Even the European Union might be doomed to collapse due to the handling of the refugees issue if the war in Syria continues, as it is likely to do.

Pedro Diogo, Economics Student

Disclaimer: This Post reflects solely the author’s opinion and do not represent the platform as a whole

Image 1: https://en.wikipedia.org/wiki/Quantitative_easing

Image 2: http://www.cbrates.com/eurozone/

Image 3: http://www.tradingeconomics.com/united-states/gdp-growth

 

 

 

 

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