JP Morgan warns next financial crisis is coming soon

They say history never repeats but on the 10th anniversary of the 2008 Lehman Brothers collapse which froze economies and plunged the world into the worst recession on record, Wall Street’s largest investment bank has predicted the onset of a round two financial crisis within the next 24 months.

Strategists at JP Morgan Chase & Co have created a predictive model aimed at gauging the timing and severity of the next slump and they’ve circled 2020 as the year it will likely strike.

The model calculates outcomes based on length of the economic expansion, the potential duration of the next recession, the degree of leverage, asset-price valuations and the level of deregulation and financial innovation before the crisis.

Assuming an average-length recession, the model came up with a set of “peak-to-trough” performance estimates for different asset classes as part of a detailed 143-page report released this week.

The estimates returned a post-crisis economy where US stocks have declined by around 20%, US corporate bond yield premiums sit at around 1.15 percentage points, energy prices drop by 35% and base metals by 29%.

The report also predicted a 48% decline in emerging market stocks and a 14.4% decline in emerging currencies.

“The forces that have transformed markets in the last decade, namely the rise of computerised trading and passive investing, are setting up conditions for potentially violent moves once the current bull market ends,” the report stated.

Good and bad news

The bad news is that while the exact timing of the next economic downturn is uncertain, the event itself can’t be avoided.

The good news according to JP Morgan, is that the coming slump is expected to be milder than the last, with its severity determined by the speed in which banks can hike interest rates and reverse bond purchases if markets fall by 40% or more.

“If central banks can head off the worst of a crisis by providing a floor for asset prices [in a crisis], then the status quo will probably be maintained,” analyst Marko Kolanovic said in an interview with CNBC earlier this month.

“If they don’t manage to, then you’re spiralling into depression, social unrest and a lot more disruptive changes that can negatively affect returns for a very long time.”

Mr Kolanovic previously concluded that a shift from actively-managed investing – through the rise of index funds, exchange-traded funds and quantitative-based trading strategies – to passive investing had escalated the danger of market disruptions.

“The shift from active to passive asset management, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns,” he said.

A market in crisis

When global financial services firm Lehman Brothers filed for bankruptcy in September 2008, the world’s economy slipped off the edge, sparking a deep depression where millions of people lost their jobs and homes, the stock market was decimated and interest rates slashed to their lowest in history.

In March 2009, the Standards & Poors 500 – an index of 500 large-cap stocks representing the leading industries of the US economy and peaking at an all-time high in 2007 – sunk to close at 677 – representing a fall of over 50% from its peak and making it the worst recession fall since World War II.

Consumer sentiment plummeted as people across the world tightened their belts in fear of what was to come, and governments struggled to rescue giant financial institutions which faced serious liquidity issues as the fallout worsened.

In the years following the crash, those same governments began to introduce fiscal strategies and multi-billion dollar stimulus packages designed to boost spending and kickstart floundering economies, with a view to reversing the damage that had been done.

For its part, Australia’s Rudd government introduced a $42 billion package in February 2009, doling out cash payments to more than 13 million Australians in an effort to stunt the domestic recession and limit further job losses.

An estimated 8.7 million Australian workers received a means-tested payment of up to $950 as part of the plan, which also threw $26 billion at road, home and school building projects.

Banks can fail

Before the Lehman Brothers crisis, many people believed the banks were too big to fail and that the world’s financial systems would hold up under pressure.

In the aftermath of the crisis, international standard-setters introduced bank regulatory frameworks that took a systemic approach to risk.

Banks became subject to higher risk-based capital, leverage capital, and liquidity requirements, and tools for resolution were created to protect taxpayers.

“Capital and leverage ratios for banks are now significantly stronger [than in 2008] and the so-called “too big to fail” global banks have never been better positioned from a solvency and liquidity point of view going into the next potential recession,” said JP Morgan’s report.

“We will enter the next crisis with a banking system that is stronger than it has ever been. The trigger to the next crisis will not be the same as the trigger to the last one – but there will be another crisis.”

Economic indicators showing signs

JP Morgan said the timing of the next financial slump will largely be determined by “the pace of central bank normalisation, business cycle dynamics, and various idiosyncratic events such as escalation of trade wars waged by the current US administration”.

Economic indicators signalling that the crisis could be fast approaching include an inverted yield curve, which occurs when short-term interest rates exceed long-term rates, and a widening high-yield spread as a result of investors fleeing riskier investments and creating a divide between high-yield bonds and Treasury notes.

Spiking volatility in stock options and declining consumer sentiment marking a pullback in discretionary spending can also warn of tough times ahead.