Black swans that could rock financial markets

The U.S. economy is booming, Apple’s market cap just soared above $1 trillion and the Australian market is trading near a 10-year high. Happy days.

Some believe that the stock market is one of the most reliable indicators of future economic activity and if valuations are an indicator of expected future returns, then it is safe to say that investors are confident that the “party” will continue.

Unless of course it won’t.

I’m not known to be a doomsayer, but current valuations make the market vulnerable to economic shocks. Financial crises – small or big - are likely to happen somewhere in a monetary tightening cycle, especially when a lot of money chased high yielding assets in the easing stage of the cycle. This has happened on an unprecedented scale over the past ten years.

It is important to understand that an orderly share market correction can be something positive – corrections are an integral part of the cycle as excess speculation is “washed out”. After all stock valuations can’t and shouldn’t rise eternally.

However, the reality is financial markets often fall fast and sharp and tend to surprise investors if they are not prepared. I believe there are a number of black swans that could disturb the still waters and literally rock financial markets over the coming months.
 

Deutsche Bank collapse unlikely yet possible

Deutsche Bank, Germany’s largest lender by assets, had an ugly decade filled with financial penalties, scandals and numerous leadership changes.

The stock has lost over 35% since the beginning of the year and a staggering 80% over the past 20 years (August 1998 vs August 2018). To put this into perspective, shareholders who bought the stock in August 1998 have seen a compound annual loss of nearly 8% per year (excluding dividend payments).

While Germany’s manufacturing sector is known for its excellence, the banking sector has lagged international peers, and quite surprisingly, Deutsche Bank has performed worse than some of the Italian or Spanish lenders. Earlier this month, the Federal Reserve designated Deutsche Bank's US business as “troubled”, one of the many obstacles the German lender has faced across the Atlantic. Since 2000 the bank has racked up penalties in excess of U$12 billion, approximately half of today’s market cap.

Turning around this business feels like manoeuvring the Titanic. Is the iceberg is still looming? It appears Deutsche Bank is heading straight for it, and if the recently appointed CEO Christian Sewing can revive the bank remains to be seen.   

We see potential for a turnaround, but the bank has not found its identity yet and the clock is ticking fast. If the bank was to collapse it would send shock waves of unprecedented size through financial markets.
 

The global debt crisis

The global debt to GDP ratio is the highest since WW2, but financial markets appear very relaxed about the potential implications of global debt. Data compiled by the Institute of International Finance (IIF) showed that global debt rose by over U$8 trillion in Q1 2018 to over U$247 trillion which equates to 318% of GDP.

Emerging market debt rose by $US2.5 trillion to a record $US58.5 trillion in the first quarter.

Some economies with a debt-to-GDP ratio of over 100% - including Italy, Greece or Japan – are particularly sensitive to interest rate and currency movements, but these risks are certainly not contained to individual countries in today’s globalised world.

As President Trump continues to promote his “pro-growth” policies, the US national debt is forecasted to grow significantly over the coming years. GDP is on track to rise 4% per annum, but as debt spirals out of control, it will become harder and harder to stimulate the economy and generate future growth – which the country desperately relies on.

Investors close their eyes on debt as it won’t affect investments here and now – which may be true – but as the global debt continues to grow and emerging economies remain somewhat unstable, investors and policymakers need to pay attention to this problem while its small before it becomes a big one.
 

Turkey, Brazil & emerging market assets

The market got used to the ongoing ideological and political tensions between Turkey and the European Union, but as the political and economic crisis in Turkey intensifies President Recep Tayyip Erdogan is showing no signs of backing down in a standoff with the U.S. The Turkish lira is in freefall and while the central bank promised to boot liquidity, we believe risks remain elevated.

But why would such a small country like Turkey be a problem? After all the consolidated market capitalisation of all companies listed on the Borsa Istanbul is approximately the same size as online streaming provider Netflix.

The economic implications appear containable. While EU lenders have exposure to Turkey, it represents only a small portion of the overall lending portfolio. Meanwhile, other emerging markets have strong trade links with Turkey but even those relationships appear somewhat containable. I believe the real risk are the potential impacts on market sentiment and the trust in the stability of the global financial system. Furthermore, Turkey’s woes could spread to financial markets and indirectly impact other vulnerable emerging economies – and there are many as explained in the previous point – while a collapse could test the stability of the overall financial system. Countries like Brazil or South Africa are at risk amid ongoing political uncertainties.

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