Breaking News
Get Actionable Insights with InvestingPro+: Start 7 Day FREE Trial Register here
Investing Pro 0
Ad-Free Version. Upgrade your Investing.com experience. Save up to 40% More details

Could The Fed Trigger The Next “Financial Crisis”

By Lance RobertsStock MarketsNov 29, 2021 05:08AM ET
www.investing.com/analysis/could-the-fed-trigger-the-next-financial-crisis-200609799
Could The Fed Trigger The Next “Financial Crisis”
By Lance Roberts   |  Nov 29, 2021 05:08AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 

Could the Fed trigger the next “financial crisis” as they begin to hike interest rates? Such is certainly a question worth asking as we look back at the Fed’s history of previous monetary actions. Such was a topic I discussed in “Investors Push Risk Bets.” To wit:

“With the entirety of the financial ecosystem more heavily levered than ever, the “instability of stability” is the most significant risk.

"The ‘stability/instability paradox’ assumes all players are rational and implies avoidance of destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’

"The Fed is highly dependent on this assumption. After more than 12 years of the most unprecedented monetary policy program in U.S. history, they are attempting to navigate the risks built up in the system.

The problem, as shown below, is that throughout history, when the Fed begins to hike interest rates someone inevitability pushes the “big red button.” Such has been the case each time.

Federal Reserve and Financial Crisis
Federal Reserve and Financial Crisis

The behavioral biases of individuals remain the most serious risk facing the Fed. While they may hope that individuals will act rationally as they hike rates and tighten monetary policy, investors tend not to act that way.

Importantly, each previous crisis in history was primarily a function of extreme excesses in one area of the market or economy.

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that
  • “Portfolio Insurance” was the “thing” in the mid -80s
  • Dot.com anything was a great investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2007 was a doozy

What about currently?

A Bubble In “Everything”

No matter what corner of the market or economy you look at, there are excesses.

  • Real estate,
  • FANG-NATM (Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOGL), Nvidia (NASDAQ:NVDA), Amazon (NASDAQ:AMZN), Tesla (NASDAQ:TSLA) and Microsoft (NASDAQ:MSFT))
  • EVs – Tesla is a $1 Trillion dollar company
  • Corporate debt
  • Credit
  • Private equity
  • SPACs
  • IPOs
  • “Meme” stocks
  • Options speculation

The list could go on, but you get the idea.

There is a correlation between the Fed’s interventions and the surge in speculative risk-taking. As shown, household equity ownership is highly correlated to the Fed’s balance sheet.

Household Equity Ownership vs Fed Balance Sheet
Household Equity Ownership vs Fed Balance Sheet

Unfortunately, in order to invest in the financial markets, individuals must have disposable income with which to invest. However, while the massive interventions by the Fed inflated the most prominent financial bubble in history, it did little to boost economic growth or prosperity. As a result, the top 10% of income earners own roughly 90% of the financial market assets.

Household Equity Ownership by Bracket
Household Equity Ownership by Bracket

Not surprisingly, after more than a decade of ultra-accommodative monetary policies, risk appetites surged as participants came to believe the Fed eliminated all “risk.”

Of course, if there is “no risk of loss,” why not take on more risk? Such is exactly what everyone did.

A Bubble In Leverage

In Seth Klarman’s famous book, “A Margin Of Safety,” he discussed the 1980’s bond mania before it imploded. At that time, many companies issued bonds even though they could not afford to pay the interest expenses. Today, we call such companies “zombie companies,” as they must feed on cheap debt to stay alive. Currently, the market capitalization of these zombie firms is at a record.

Total EV of Firms with EBIT Less than Interest Expense
Total EV of Firms with EBIT Less than Interest Expense

Chart courtesy of Kailash Concepts

The obvious problem is what happens when they cannot refinance their debt. Unfortunately, as Kailash Concepts explains, debt itself is a significant risk.

Currently, the world is awash in financial alchemy. There is currently a record number of companies unable to cover their interest expense from profits.

"Since 2007, a big part of America’s debt crisis has moved from the financial sector to non-financial stocks with too much debt. We believe the mix of record debt and record equity valuations is likely a side effect of real rates approaching lows last seen in 1973. Whether we are right or wrong on the causality, the facts are intimidating in our view.

"Our research has documented that the world has never been less prepared or less equipped to deal with a possible outbreak of inflation or pull-back in Federal largesse."

The Debt Crisis In American Equities
The Debt Crisis In American Equities

However, it isn’t just a corporate leverage bubble. It is also a bubble in investor leverage as individuals take on debt to chase markets.

Margin Debt Free Cash Balances
Margin Debt Free Cash Balances

Of course, the critical thing about “margin debt” is that it fuels the bullish advance. But, unfortunately, it also accelerates the market’s eventual decline as leverage reverses. Such is always a brutal and mauling event, which is why Wall Street calls it a “bear market.”

The Risk Of A Policy Mistake Is Enormous

In “Rising Interest Rates Matter” we discussed how if interest rates rise, the Fed tightens monetary policy, or the economic recovery falters, a financial crisis is possible.

“In the short term, the economy and markets (due to current momentum) can DEFY the laws of financial gravity as interest rates rise. However, they act as a ‘brake’ on economic activity as rates NEGATIVELY impact a highly levered economy:”

  • Rates increases debt servicing requirements reducing future productive investment
  • Housing slows. People buy payments, not houses
  • Higher borrowing costs lead to lower profit margins
  • The massive derivatives and credit markets get negatively impacted
  • Variable rate interest payments on credit cards and home equity lines of credit increase
  • Rising defaults on debt service will negatively impact banks
  • Many corporate share buyback plans and dividend payments are done through the use of cheap debt
  • Corporate capital expenditures are dependent on low borrowing costs
  • The deficit/GDP ratio will soar as borrowing costs rise sharply

Most importantly, over the last decade, the primary rationalization for overpaying for equity ownership is that low rates justify high valuations. Unfortunately, with inflation surging, which shrinks profit margins, and the Fed set to hike rates, valuations are likely a bigger issue than most suspect.

Household Equity Ownership Vs Valuations
Household Equity Ownership Vs Valuations

As Mohammed El-Erian stated in a recent interview:

“Investors should keep an eye on the risk of an abrupt shift from a relative valuation market mindset to an absolute valuation one. If that happens, you should stop worrying about the return on your capital and start worrying about the return of your capital.”

However, for now, there is no reason to worry about the next “financial crisis.”

Well, that is unless someone pushes the “big red button.”

Could The Fed Trigger The Next “Financial Crisis”
 

Related Articles

Michael Kramer
NASDAQ Could Fall Another 13% By Michael Kramer - Jan 28, 2022 2

This article was written exclusively for Investing.comThe NASDAQ Composite has fallen sharply to start 2022, down nearly 13%. But don't expect the index to race back to record...

Could The Fed Trigger The Next “Financial Crisis”

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with other users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind:  

  •            Enrich the conversation, don’t trash it.

  •           Stay focused and on track. Only post material that’s relevant to the topic being discussed. 

  •           Be respectful. Even negative opinions can be framed positively and diplomatically. Avoid profanity, slander or personal attacks directed at an author or another user. Racism, sexism and other forms of discrimination will not be tolerated.

  • Use standard writing style. Include punctuation and upper and lower cases. Comments that are written in all caps and contain excessive use of symbols will be removed.
  • NOTE: Spam and/or promotional messages and comments containing links will be removed. Phone numbers, email addresses, links to personal or business websites, Skype/Telegram/WhatsApp etc. addresses (including links to groups) will also be removed; self-promotional material or business-related solicitations or PR (ie, contact me for signals/advice etc.), and/or any other comment that contains personal contact specifcs or advertising will be removed as well. In addition, any of the above-mentioned violations may result in suspension of your account.
  • Doxxing. We do not allow any sharing of private or personal contact or other information about any individual or organization. This will result in immediate suspension of the commentor and his or her account.
  • Don’t monopolize the conversation. We appreciate passion and conviction, but we also strongly believe in giving everyone a chance to air their point of view. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
Comments (2)
Franklin Hazzard
Franklin Hazzard Dec 01, 2021 5:20AM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
Makes since why Nadella sold half his shares in Microsoft now. You gotta know when to hold-em and know when to fold-em.  I think he knows something.
John Niemokta
John Niemokta Nov 29, 2021 9:14AM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
Good read!
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.
Continue with Google
or
Sign up with Email