When Queen Elisabeth II asked “Why did nobody notice it?” referring to the looming financial crisis of 2008, a wise economist at the Bank of England replied that financial crises are as hard to predict as earthquakes and flu pandemics. They just happen. Of course, seismologists know where the active zones are. And medical specialists may well know the nature of the next virus type. But whether either a particular active zone or a particular virus type will turn into a ‘Big One’ remains elusive, even to the specialists. The same holds for financial markets, as a look at the crises of the past 90 years shows (see chart).
To measure the severity and duration of the individual crises, we used the price fluctuations in one of the world’s leading financial markets – the S&P 500. The chart’s ‘fever curve’ gives an indication of price fluctuations or volatility. The mother of all financial crises was the 1929 meltdown, followed by a relapse into recession in the late 1930s. Thereafter, nothing has come even close to those early traumatic experiences. The next 30 years or so witnessed further crises, but they were much smaller in scale. Surprisingly the Cuban crisis in the early 1960s was not in the ‘Armageddon’ league by historical comparison (it was in fact not even a ‘Big One’). Still, at the time it felt like the world was about to end.
Lesson #1: Even crises that turn out to be small by historical standards feel at the time like the end of the world.
There seems to be a pattern to the frequency of crises. In the chart we counted a total of 27 spikes in the past 90 years, which makes the average interval between two crises about three years and four months. Out of the 27 crises, more than half were minor crises and shocks. The surprise rate hike in 1994 and the subsequent emerging market shocks (Mexican crisis in 1995, Asian crisis in 1997, Russian crisis in 1998) were such events. Other, even more significant shocks that are alive and kicking in investors’ memories are the Cuban crisis and the bursting of the tech bubble followed by 9/11. So in terms of frequency and timeline, we can note another lesson:
Lesson #2: Investors have to expect a financial crisis slightly more often than every three-and-a-half years.
Taking the most severe crises together, we add another three events to the two during the Great Depression: the oil shocks in the 1970s, the 1987 crash and the Great Financial Crisis. These are iconic and prevail in collective memory. A crisis of such severity occurs roughly every 20 years, i.e. about once in a generation. This gives us our third lesson:
Lesson #3: Every generation gets a ‘Big One’, i.e. a crisis that shapes their collective memory.
What is the opposite of a crisis?
When looking at the latest readings of the fever curve in 2017, we note that markets currently trade at the other end of the scale. In fact, price fluctuations are at all-time lows on the data set in the chart. Doomsayers may bet that now ‘the only way is up’, i.e. all hell needs to break loose as stable periods in the past did not last for long. ‘Not so fast’, I would say. Every low volatility point in the past was followed by a two-year interval before the onset of the next financial crisis. So unless there is a severe unexpected shock to the system, the likelihood of running straight into crisis mode at the outset of 2018 seems rather limited. So
Lesson #4 is: Calm markets have historically tended to take quite some time before switching into crisis mode.
The ingredients for disaster
Patterns aside, there are of course fundamental reasons for most crises. In their landmark ‘This Time is Different’, Reinhart and Rogoff identify four common factors underlying all crises:
- Capital-flow bonanzas: investors piling money into an asset class or region as if there was no tomorrow. The ‘tiger states’ in Asia that prompted the Asian crisis in the late 1990s are a good example of this.
- Financial innovation: some cynics claim that the last financial innovation was the automated teller machine (ATM) back in 1966. Unfortunately, that is not true. A more recent example is the subprime crisis: US banks were incredibly innovative in securitising their mortgage books. With well-known consequences.
- Housing booms: ditto; see the US example more than a decade ago, or the Swedish experience in the early 1990s.
- Financial liberalisation: for instance during the Reagan years, when the government massively reduced financial regulation. To claim that the 1987 crash was the result of financial deregulation seems rather daring to me, though.
Lesson #5: Capital-flow bonanzas, financial innovation, housing booms and financial liberalisation are the fundamental ingredients for financial crises.
So – where are we today and when is the next one due?
In view of the natural rhythm and frequency of the average financial crisis as well as the current record-low temperature in markets, the next financial crisis should not be with us before 2019 (roughly four years after the commodity crisis in 2015/2016) and a generational shocker should not occur before 2025 (roughly 18 years after the Great Financial Crisis). Looking at the four factors identified by Reinhart and Rogoff, we see that only one of them applies (and only partially so). You could indeed claim that we have seen a capital-flow bonanza, particularly in fixed income as rates have reached ever new lows recently. More extravagantly, the rise of cryptocurrencies, with bitcoin as the poster child, points to similar excesses. As for the other three factors, we struggle to find them: financial innovation seems far off, with banks busy downsizing businesses and increasing their capital bases in the past few years. Housing booms can be spotted in some places, such as Silicon Valley, tier-1 Chinese cities, Sweden and Germany, but they are not as broad-based as back in 2007. And certainly, the most important economy, the US, is still far away from a major housing bubble. Finally, financial liberalisation is still far out, as regulatory burdens have steadily increased worldwide in the past decade as a consequence of the Great Financial Crisis.
Doomsayers do not have a strong case right now
To conclude, then, while it makes sense for investors to have the nature and preconditions of financial crises on their radar screens, a closer look at historical patterns and fundamental reasons does not suggest an increase in the odds of another financial crisis. This does not mean, of course, that stock markets will not see a correction of (say) 5%+ this year, or that an unprecedented external shock cannot trigger a major meltdown. All we want to convey to investors is that the usual doomsayers do not have a strong case at the moment and that their shocking statements should be taken with a ‘rock’ of salt. The next financial crisis will hit markets at some stage – that is what history tells us. Whether it will be in the next 12 to 24 months is highly doubtful.