Financial Crisis 2020 Part 2/2

The two factors that will lead to the crisis in 2020

In most industrialized countries, there are two headwinds that threaten the growth of the past decade:

1.

a) End of QL and rising interest rates
b) Inequality and the rise of sociopolitical instability

2.

(a) Rising interest rates and the return of asset prices to average

Put simply, when the debt-to-GDP ratio exceeds a certain point (between 100% and 200% depending on the country, central bank president and macroeconomic climate), central banks tend to tighten monetary policy by raising the base rate. They will also set stricter criteria for bank lending (e.g. which sector, LTV rate, etc.), usually in the form of more stringent stress tests.

There are four main reasons for tightening monetary policy:

• Central banks want to keep inflation low: As economic growth gains momentum, price levels tend to rise, leading to inflation. The base rate becomes the primary regulator as it cools economic growth. The central banks have to raise it to control inflation.

• Controlled debt relief: When the total debt in an economy exceeds a certain threshold, a large portion of GDP will go into interest payments, which is not the most productive use of capital. When companies pay an increasing share of their profits for interest on loans, this means that investment in their employees is lost (through training or better remuneration, which can ultimately be used to boost growth) and lower tax revenues. Both are bad for economic growth.

• Central banks want to create an environment for greater capital allocation efficiency: In conjunction with number 2, a flat low rate across all borrowing may not allow capital to flow into the most productive sector. Therefore, central banks may try to channel capital into the desired sectors by adopting stricter/selective lending criteria.

• Central banks want to slow down growth to prevent severe overheating, which will lead to even worse crises: Investors believe that the markets will become nervous when the debt ratio exceeds a certain threshold, and that governments’ borrowing costs will therefore automatically increase. Central bankers therefore want to proactively slow down growth to avoid overheating and boost confidence.

Until recently, interest rates have moved in line with the debt ratio. Source: ResearchGate

The overall effect is that debt capital becomes more expensive and more difficult to access. The immediate effect would be a decline in demand for financial and tangible assets, which would lead to a fall in prices. If this is mishandled, it can lead to a vicious circle in which:

• The price of assets falls, resulting in a decline in valuation;
• The upper limit of debt is exceeded, resulting in less credit being available;
• Investments decrease and income (profits) fall;
• The business becomes less valuable due to lower profitability, leading to a further decline in valuation;
• If this spreads to the whole economy, growth comes to a standstill.

b) Inequality and the increase in socio-political instability lead to the rise of populism and ultimately to greater economic decline

The rapid rise in asset prices as a result of central bank policies had the unintended consequence of exacerbating economic inequality in industrialised countries. Three factors contributed in equal measure:

• The increased asset price (triggered by this policy) benefited those with assets. This meant that the gap between people with and without assets widened;
• The increase in the price of assets also made assets less affordable, reducing the likelihood of people who had no assets ever acquiring them -> people who already had assets could continue to acquire assets and increase their holdings -> the gap widened;
• As a result of the reduction in interest rates, the cost of acquiring assets is much lower than before. Borrowing at low interest rates became available only to people who already had assets.

Thus, the poor become poorer while the rich (who own growing assets) become richer.

“We have to worry about the wealth gap and the geopolitical consequences”, Ray Dalio

The link between increasing inequality, growing social cohesion and related political instability is well documented. Inequality fuels populism, as we have seen with the brexite, the election of Trump, Salvini and the rise of AfD in Germany. Populist policies have in the past been a threat to long-term economic growth. As a result, investor confidence in the future prospects of the global economy is declining.

What will happen to your portfolio if the next tsunami occurs?

Let’s assume that you are in the middle of the next market downturn. What will happen this time? What does it feel like? How will you react?

Let’s consider a hypothetical chain of events that could develop in the foreseeable future:

• After two years of chaotic negotiations, Britain exits the EU with no exit agreement and sends its entire economy into uncharted waters.
• The pound reached a 30-year low against the dollar.
• Protests in the streets led to the resignation of Prime Minister May, and parliamentary elections were held in which Jeremy Corbyn, a staunch socialist, was elected.
• As a result, business confidence fell and corporate investment declined.
• In the midst of the chaotic political scene, many of the EU derivative contracts concluded in London became legally unenforceable, causing massive losses to the owners.
• Market confidence fell and the FTSE 100 fell 15% at the end of the week and 30% at the end of the month.
• The British economy suffered a sudden downturn. Due to historically close trade links, it spread throughout the EU.
• The slowdown in the EU has in turn spread to its trading partners around the world.
• Investors began to doubt the health of the global economy and the major indices suffered a dramatic fall, falling 25% by the end of the month.

In this hypothetical case, you can see the potential impact on your $100,000 portfolio, which consists of geographically and sectorally diversified ETFs consisting of the classic 60-40 combination of stocks and bonds:

• The equity portion of your portfolio will decrease by 25% from $60,000 to $45,000
• The bond component is more resilient, but can still fall by 15% from $34,000 USD;
• As a result, your portfolio will now be worth $79,000, down 21%.
• Corporate profits can be reduced during a downturn, which has a direct impact on the dividend payout. It is quite possible that dividend growth rates will fall by more than 15%.

These are real and nominal revenue and valuation losses that have a profound impact on investor psychology and can lead to panic selling that exacerbates the market downturn.

What can you do to isolate your portfolio now?

The easiest way to preserve the value of your portfolio during a downturn is to diversify your risk concentration before the market fully appreciates the risk.

If we look at the risk spectrum, in an ideal world we need an asset that meets the following 2 criteria:

• Location in a jurisdiction with high political, economic and legal stability and a favourable business environment. These factors are important for maintaining value;
• The ability to generate stable and rising incomes that allow for appreciation in value.

Swiss real estate immediately comes to mind.

As a nation, Switzerland has some advantageous characteristics:

• It is a small, stable and neutral country;
• It is home to a highly developed economy;
• As a nation that maintains close bilateral relations with the EU and accepts freedom of movement, it has above-average population growth;
• The number of tourists per year has grown steadily by 3% even during the Great Recession.
• The real estate supply is relatively inelastic (limited availability). Therefore, as demand rises, the average rate per night increases, thus raising potential income.

The Swiss real estate market is historically balanced. Recently, the curve has been somewhat more aggressive due to the factors mentioned above. Thanks to strong support on the demand side, property prices have remained stable during the Great Recession, making it an attractive hedge against market fluctuations elsewhere.

Wie komme ich zum Schweizer Immobilienmarkt?

Es gibt verschiedene Ansätze, und die genaue Methode hängt von den persönlichen Vorlieben und Umständen der Anleger ab.

Conclusion

We have enjoyed a decade of exceptional returns in the financial markets. Such a long period of stability can often cloud our judgment and make us believe that this is the norm. But history teaches us that this is far from the truth. The financial market is volatile and there are warning signs across the spectrum that a downturn may be imminent. Fortunately, in today’s marketplace, investors have many options available to them to help reduce risk while maintaining a balanced return on investment.

Source: Starwerk.ch