Catalysts for the Next Financial Crisis

May 23, 2018

What are the catalysts for the next financial crisis? On America's west coast reside a variety of geologic fault lines whereby the earth's large, shifting tectonic plates butt up against one another. Sometimes, these tectonic plates -- and the fault lines where they meet -- shift and move in such a way that we hardly notice without the aid of seismic monitoring technology.
Other times, however, these machinations occur in such violent fashion that the resulting earthquakes can destroy much of that which rests upon them.
Analogously, economic fault lines exist, which could act as catalysts for the next financial crisis, exposing the massive tectonic plates that ebb and flow beneath the global economy. On occasion, the shifting economic plates result in downturns in indicators by which their monitored. But sometimes, the shifts cause massive disruptions to the sovereign and global economies. Wreaking financial havoc upon the economic participants that rest upon them.

Clients often ask when we believe the next recession will occur, or what the catalysts for the next financial crisis could be. Followed by our opinions on what could catalyze the next downturn. As if seismological economic warnings will alert us to danger well in advance. Unfortunately, that is not the case.
While we have specific recession indicators that we rigorously follow month after month, we would be less than genuine were we to state that we've any foolproof insights here. Consider how many brilliant Wall Street and economic insiders completely missed the mile markers leading up to the Credit Crisis? Like squirrels watching a bank robbery, none of the economists - and precious few investors - noticed anything important happening. Until it was too late.
There do exist, however, insightful and original thinkers at respected research shops who spend all their time delving into these topics. Generating insights that can, at the very least, illuminate some of the less obvious and troubling concepts roiling beneath the surface of the economic tidal flows.
Among the more astute such observers are the analysts at DataTrek Research, who recently offered an intriguing look at the possible reasons the broad market could stumble later this year or next. Eschewing common reasons like central bank over-stimulation, over-reliance on credit, and too much government spending (keys to the great financial crisis of 2008), reasoning that "ghost stories are rarely scary the second time you hear them." They added: "The usual reasons are too much like the root causes of the 2008 Financial Crisis. Excessive debt is bad and central bankers, being human, get things wrong. We get it."
Accordingly, here is DataTrek's short list of the more idiosyncratic narratives that could provide the catalysts for the next financial crisis, reproduced nearly verbatim:
"1) Robots and Recessions. We recently saw a survey of economists that concluded the next US recession would not hit until 2020. Presumably, that was meant to be a comforting thought.
Moore's Law says it is actually cold comfort at best. Two years is just about enough time to see another 100% increase in computing productivity, including artificial intelligence, robotics and sensor technology. Companies typically use recessions as an opportunity to reduce structural labor costs. If they also replace labor with capital - and there will be plenty of options for that in 2020 - then the next upcycle for employment will be far less pronounced.
The upshot: even a mild economic downturn could easily turn into a nasty and long-lasting recession.
2) The balance of power in global Technology is shifting from liberal democracies to authoritarian governments. You can drive to the world headquarters of Apple, Facebook and Google in northern California, then fly 2 hours to Seattle to see Amazon, and still not fill an entire day's itinerary. You would, however, have seen the 4 companies most responsible for our current tech-enabled world.
China has a stated national policy to beat them all in new technologies like artificial intelligence by 2030. This essentially pits a powerful global economy with 1.2 billion people against a handful of US privately owned companies. Moreover, the Chinese government's interest is not merely economic; technology is highly useful to maintaining social order and cohesion, two values they hold in high regard.
Ever since the Enlightenment, the preeminence of the individual has been a central tenet of the West's notion of social progress. That's why everyone from the NSA to Facebook has had to testify in front of Congress on how they safeguard personal privacy. If that slows technological progress or limits government's power, so be it.
The Chinese model differs considerably, of course, and it gives them a real edge. The more high-quality data you push through an AI model, regardless of its sources, the faster it develops. The more aggressive you are in training the next generation of technologists, the quicker they will find the next "Big Thing".
The conclusion: markets extrapolate future from past, and US dominance in Tech is a bedrock assumption based on decades of experience. Fair enough, and there is scant history that shows any economic model can beat truly private ownership of human and physical capital over the long term. But there is always a first, and China is clearly going to give big US Tech a run for its money.
3) The Ghost of Disruption Future. Taken as a whole, US equity markets suffer no discount for living in an age of profound technological disruption. At 16.5x forward year earnings, the S&P 500 is priced for sustainable future earnings growth against a backdrop of still low interest rates. And remember what that a P/E ratio actually "says": it will take +16 years of constant earnings and no inflation to earn back the share price.
This assumption would still make sense if the disruptors were as commonly represented in the S&P 500 as the disrupted. That is not the case, however. In the current investment cycle, venture capital owns much of the former, leaving public equity investors holding the bag on the latter. Yes, companies like Amazon or Google may eventually buy those companies and make them indirectly available to investors. But the first $100 billion of value creation will go to founders and VCs."
Summing up? As far as the catalysts for the next financial crisis are concerned, we should not completely discount traditional bearish arguments. We simply don't think they meet the requirements for a real investment case, as they are so often discussed. Lacking, therefore, the power to shock and awe. DataTrek's three points about the future of technological disruption get much less attention but are no less impactful.
Vision, as Jonathan Swift remarked, is the art of seeing what is invisible to others.
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