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opinion

The downturn in world stock markets, rising interest rates, stubbornly persistent inflation and mostly disappointing economic statistics are trying the patience of economic optimists.

But this economic downturn is an unusual one by historical standards: Unemployment is still low, for now, and inflation has accelerated far faster than even the experience of the 1970s.

Could the ingredients be in place for the next global financial crisis? History provides a few clues of what may lie ahead.

The 1981-82 recession was severe and unemployment was high. This period led to a crisis as financial institutions began to appear shaky. Some even feared for the health of major banks as loan losses spiked. The period of the early 1980s was an example where economic problems begat a financial crisis.

In contrast, the 2008 downturn was an example of a financial crisis causing an economic downturn. Low interest rates and irresponsibly low credit standards resulted in a bubble as assets, including housing, exploded in price above any semblance of true value. When the inevitable correction occurred, some major financial institutions that pushed the risk envelope too hard almost brought the entire financial system down. This resulted in a drop in the S&P 500 of about half its peak value and years of below-trend economic growth.

In both cases, financial institutions were tested. Some did not make it but, most importantly, the system survived and prosperity eventually returned.

Most have forgotten by now that even the much-vaunted Canadian banks had difficulties in the early 1980s. The banks saw large loans losses that affected their capital ratios. Many Canadians were worried, and for those of us living through it at the time, the underpinnings of the Canadian financial world seemed to be falling apart.

But fundamental changes were made to the businesses, and when the economic recovery came later in the 1980s, there was a general consensus among government, financial officials and even many in the public that Canadian financial institutions would be far better prepared to withstand any future financial crisis. The “four pillars” of the financial institutions – banks, insurance companies, trust companies and stockbrokers – that had previously been kept separate were allowed to merge. The banks basically took over the trust companies and the large stockbrokers, and eventually would be allowed to sell insurance. Turning the Canadian financial system into even more of an oligopoly may have forced Canadians to pay more dearly for their financial services, but it also had the effect of strengthening the balance sheets and creditworthiness of Canadian banks.

Nevertheless, investors were still caught off guard when the financial crisis of 2008 hit. The complexity of the global financial system meant credit risk was hard to assess. In 2008, you may have thought the entity you lent money to was solid, but through special instruments and derivatives, counterparty risk blew everything up.

Fast forward to today, and the complexity of the global financial system is still not easy to assess.

There are so many fissures emerging in the global financial system that it is difficult to predict which issue will be viewed by economic historians as the tipping point for the next crisis.

Perhaps it will be the mortgage market. Mortgage rates in Canada, the United States and Europe have effectively doubled – or will soon. Buyers in the past few years are especially likely to run into trouble as they bought at prices inflated by artificially low rates. As mortgages are renewed at higher rates, household cash flows will be impaired and net worth will decline.

Hedge funds are always a good candidate for starting a crisis given the propensity of some of them to use leverage. Hedge funds are incentivized to take big risks. How much debt hedge funds are currently in is impossible to determine, but it’s safe to say that those that rely on heavy leverage could find themselves in trouble.

The deterioration of China financially seems to be coming to a head. Decades of debt accumulation in the Middle Kingdom and almost unfathomably bad investments are certainly cause for concern. The question is how vulnerable the rest of the global financial system is to China.

More broadly, a sovereign debt crisis in developing countries is a real possibility depending on how exposed the global banking system is to the economic crisis we are witnessing in places such as Sri Lanka. Governments whose populations are facing mass starvation will prioritize saving lives over timely payments to foreign bankers.

There are many situations that can trigger a financial crisis – when asset prices steeply decline in value, business and consumers have trouble paying debts, and liquidity shortages hit financial institutions.

But once begun, they follow a typical pattern of panic, fear, and a mad scramble by central bankers and policy makers. Some institutions will be affected more dramatically than others, usually resulting in some form of debt write-off and some creditors taking large losses.

Given the current situation the world finds itself in – large and mounting debts, economic weakness, a costly war and impending shortages of food – the next financial crisis could be close and could even be severe. Fortunately, Canadian banks have strong potential to weather the storm thanks to their dominant position in the marketplace.

Equity investors should be careful. Valuations are still not cheap compared with the end of most bear markets. Even bank stocks could run into difficulty.

There is a potential opportunity, however, in haven government bonds. They’ve become much cheaper given that interest rates have soared in recent months, and they may be close to being an interim buy.

Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.

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