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Tough predicting what the next global financial crisis would be like

Risk still hasn't been scrubbed out, so the best insurance against this is to build a diversified portfolio, and to review it regularly.

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The system is often at its most vulnerable near the end of the global economic cycle, when excesses have built up and managing risks may have been neglected.

IT'S been 10 years since a US financial shock turned into a crisis in the global financial, market and economic system.

On Sept 15, 2008, Lehman Brothers filed for bankruptcy as the shock waves from sub-prime mortgages rocked the entire financial system, shattering confidence and leading to an economic downfall.

To be clear, we are not sounding any alarms nor do we think a crisis is imminent, but we do like to keep our eyes on the horizon.

Reforms to the global financial system in the wake of the 2008 to 2009 crisis mean the next crisis probably would not look like the last one.

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So what will it look like?

Tracking financial news reveals one thing for certain: Shocks to the global system happen all the time. Many of these shocks are absorbed by the system without much disruption.

RECENT SHOCKS

Recent examples of shocks might include last year's escalating geopolitical tensions between the US and North Korea, the US Fed beginning to reverse quantitative easing (QE), or the rapid unwinding of the short-volatility trade that took place earlier this year.

A shock turns into a crisis when the system is unprepared for it. The system is often at its most vulnerable near the end of the global economic cycle, when excesses have built up and managing risks may have been neglected.

Since we have likely reached the later stages of the cycle, it is now a good time to assess how well the system is prepared for the shocks that lie ahead and where the biggest vulnerabilities may lie.

Since 2001, global debt has nearly tripled. As of 2016 (the latest year for which International Monetary Fund data is available), global debt has swelled to 225 per cent of gross domestic product (GDP), reaching US$164 trillion, up from US$62 trillion in 2001 and US$116 trillion in 2007, just ahead of the onset of the financial crisis.

DEBT-TO-GDP RATIOS

According to the International Monetary Fund, more than a third of developed economies have debt-to-GDP ratios above 85 per cent,which is three times worse than in 2000.

While a high debt burden isn't necessarily a problem by itself, it increases the vulnerability of the system to a shock - in particular, a shock that would lift interest rates.

Central banks' QE programmes helped ease the cost of higher debt burdens by keeping interest rates low, but those programmes are winding down.

In theory, all that debt means the potential losses from a rise in interest rates would be more costly than in the past, especially combined with a stronger dollar pushing up the cost of dollar-denominated debt outside the United States.

INCREASE IN DEBT

In reality, it is hard to draw hard conclusions as to what impact an interest rate shock would have on the increasingly indebted global economic and financial system, due in part to some of that increase in debt being held by central banks that aren't leveraged or marked to market on their holdings and refund excess interest payments back to the government, unlike traditional financial institutions. Nevertheless, increasingly high debt burdens represent an increased vulnerability to a shock.

One side effect of the global financial crisis has been a general loss of faith in the political establishment across the major economies.

Populism - of both the left- and right-wing varieties - has been on the rise, posing a challenge to governments' abilities to make decisions, or, in some cases, to form governments at all.

The result may be that the willingness or ability of governments to mount an effective response to a shock is impaired and could lead to a crisis.

After a steady rise over many decades, more than half the sales of the companies that make up the world's stock market (MSCI World Index) now come from outside their home country, according to FactSet data.

Even domestic sales are impacted by increasingly interconnected global supply chains, resulting in greater vulnerability to shocks from bottlenecks or border issues than in the past.

LESS AMMUNITION

There is little room for governments to use increases in public spending or central banks to ease monetary policy in response to a shock in order to fight an economic downturn.

The pre-crisis 2007 US budget deficit of US$161 billion, or 1.1 per cent of GDP, pales in comparison to this year's projection of US$804 billion, or 4.5 per cent of GDP.

In Europe, with the exception of Germany, there is very little room for governments to engage in fiscal stimulus. Quantitative easing has left central bank balance sheets stuffed with nearly US$15 trillion in assets, and interest rates are still close to record lows - with policy rates still negative in some countries.

While a downturn that could require as much stimulus as the financial crisis is unlikely, the vulnerability posed by limited ammunition to fight a downturn could lengthen and deepen the effects of the shock.

PASSIVE INVESTING

Passive management has taken the investing world by storm, but whether that could be a source of risk remains to be seen. At the very least, the rise of passive investing represents a major change.

By definition, passive investing is a strategy typically implemented by holding securities in line with their representation in an index, offering a diversified and low-fee portfolio.

However, some fear that the mechanical investment rules of passive investing may give rise to distortions in the pricing of individual securities and might reduce diversification while amplifying investors' trading patterns on the overall market.

PREPARING FOR THE NEXT ONE

It is impossible to say when the next crisis might hit or what it will look like. Vulnerabilities have shifted, which may make the shocks that pose the greatest risk of a crisis somewhat different than those of the past.

And although there are some reasons to think that the probability of a repeat of a past crisis or something similar has eased, risk has not (and cannot) be entirely eliminated from the system.

Nevertheless, global diversification remains the key to managing risk. Investors should ensure that their investments are spread across a variety of asset classes and review their asset allocations regularly to make sure they are still consistent with their preferred time horizon and risk tolerance.

  • The writer is managing director, Charles Schwab Singapore Pte Ltd