2008 Revisited?

NEW YORK – The question I am asked most often nowadays is this: Are we back to 2008 and another global financial crisis and recession?

My answer is a straightforward no, but that the recent episode of global financial market turmoil is likely to be more serious than any period of volatility and risk-off behavior since 2009. This is because there are now at least seven sources of global tail risk, as opposed to the single factors – the eurozone crisis, the Federal Reserve “taper tantrum,” a possible Greek exit from the eurozone, and a hard economic landing in China – that have fueled volatility in recent years.

First, worries about a hard landing in China and its likely impact on the stock market and the value of the renminbi have returned with a vengeance. While China is more likely to have a bumpy landing than a hard one, investors’ concerns have yet to be laid to rest, owing to the ongoing growth slowdown and continued capital flight.

Second, emerging markets are in serious trouble. They face global headwinds (China’s slowdown, the end of the commodity super cycle, the Fed’s exit from zero policy rates). Many are running macro imbalances, such as twin current account and fiscal deficits, and confront rising inflation and slowing growth. Most have not implemented structural reforms to boost sagging potential growth. And currency weakness increases the real value of trillions of dollars of debt built up in the last decade.

Third, the Fed probably erred in exiting its zero-interest-rate policy in December. Weaker growth, lower inflation (owing to a further decline in oil prices), and tighter financial conditions (via a stronger dollar, a corrected stock market, and wider credit spreads) now threaten US growth and inflation expectations.

Fourth, many simmering geopolitical risks are coming to a boil. Perhaps the most immediate source of uncertainty is the prospect of a long-term cold war – punctuated by proxy conflicts – between the Middle East’s regional powers, particularly Sunni Saudi Arabia and Shia Iran.

Fifth, the decline in oil prices is triggering falls in US and global equities and spikes in credit spreads. This may now signal weak global demand – rather than rising supply – as growth in China, emerging markets, and the US slows.

Weak oil prices also damage US energy producers, which comprise a large share of the US stock market, and impose credit losses and potential defaults on net energy exporting economies, their sovereigns, state-owned enterprises, and energy firms. As regulations restrict market makers from providing liquidity and absorbing market volatility, every fundamental shock becomes more severe in terms of risk-asset price corrections.

Sixth, global banks are challenged by lower returns, owing to the new regulations put in place since 2008, the rise of financial technology that threatens to disrupt their already-challenged business models, the growing use of negative policy rates, rising credit losses on bad assets (energy, commodities, emerging markets, fragile European corporate borrowers), and the movement in Europe to “bail in” banks’ creditors, rather than bail them out with now-restricted state aid.

Finally, the European Union and the eurozone could be ground zero of global financial turmoil this year. European banks are challenged. The migration crisis could lead to the end of the Schengen Agreement, and (together with other domestic troubles) to the end of German Chancellor Angela Merkel’s government.

Moreover, Britain’s exit from the EU is becoming more likely. With the Greek government and its creditors once again on a collision course, the risk of Greece’s exit may return. Populist parties of the right and the left are gaining strength throughout Europe. Thus, Europe increasingly risks disintegration. To top it all off, its neighborhood is unsafe, with wars raging not only in the Middle East, but also – despite repeated attempts by the EU to broker peace – in Ukraine, while Russia is becoming more aggressive on Europe’s borders, from the Baltics to the Balkans.

In the past, tail risks were more occasional, growth scares turned out to be just that, and the policy response was strong and effective, thereby keeping risk-off episodes brief and restoring asset prices to their previous highs (if not taking them even higher). Today, there are seven sources of potential global tail risk, and the global economy is moving from an anemic expansion (positive growth that accelerates) to a slowdown (positive growth that decelerates), which will lead to further reduction in the price of risky assets (equities, commodities, credit) worldwide.

At the same time, the policies that stopped and reversed the doom loop between the real economy and risk assets are running out of steam. The policy mix is suboptimal, owing to excessive reliance on monetary rather than fiscal policy. Indeed, monetary policies are becoming increasingly unconventional, reflected in the move by several central banks to negative real policy rates; and such unconventional policies risk doing more harm than good as they hurt the profitability of banks and other financial firms.

Two dismal months for financial markets may give way in March to a relief rally for assets such as global equities, as some key central banks (the People’s Bank of China, the European Central Bank, and the Bank of Japan) ease more, while others (the Fed and the Bank of England) will remain on hold for longer. But repeated eruptions from some of the seven sources of global tail risk will make the rest of this year – unlike the previous seven – a bad one for risky assets and anemic for global growth.