With bond and equity markets stretched and “possibly the most elevated in aggregate… history,” a Deutsche Bank report takes a frank look at the potential for the next financial crisis. Considering a statistical analysis of the financial crisis and correlated factors, there are several conditions that currently stand out. While over the past few years, a crisis has been predicted by many including prominent investors, it is rare to see a big bank make such a dire forecast.

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Ahead of next financial crisis, Valuations are currently stretched to levels not seen in hundreds of years

Looking back more than 200 years ((and in some cases 800 years (although BAML going back 5k years is still way ahead) See below)), Deutsche Bank measures valuations in 15 developed market bond and stock markets and draws the conclusion that market valuations are stretched meaningfully past historic norms.

The determine historic valuation levels for stocks, Deutsche Bank researchers Jim Reid, Craig Nicol, Nick Burns and Sukanto Chanda had somewhat of a challenge.

“For equities it’s more difficult to assess partly because they are a real asset and therefore today could be a good time to buy if one felt that despite relatively high valuations, inflation may permanently increase (or better still real GDP growth) and thus lead to eventually permanently higher earnings notwithstanding any short-term negative implications of the inflationary transition,” the report, titled “ The Next Financial Crisis ,” noted.

To measure stock valuations looking back before the founding of the New York Stock Exchange, however, researchers considered price / earnings ratios relative to nominal gross domestic product. For bond markets, at the lowest yields and highest prices in history, the calculation was not as challenged. They concluded, “an equally weighted bond/equity portfolio has never been more expensive.”

But it is not just stocks and bonds that are overvalued. “This includes valuations in many asset classes, the incredibly unique size of central bank balance sheets, debt levels, multi-century all-time lows in interest rates and even the level of potentially game-changing populist political support around the globe,” they point out, speculating a crisis could occur within the next 2-3 years. “It would be hard to look at these variables and say that there was no way of spotting them.”

Surprise if the most significant correlation factor in next financial crisis, but debt is also highly correlated

The report noted most financial crises primary causation trigger are based on factors that are not considered -- surprise elements. This points to the benefit of publicly modeling different market crash scenarios.

The report noted that market crisis is occurring more frequently and there is a statistical correlation with monetary liberalism.

“It would… take a huge leap of faith to say that crises won’t continue to be a regular feature of the current financial system that has been in place since the early 1970s,” the report opined as it considered stock market shocks in developed markets of more than -15% and negative bond, currency and inflation changes of more than 10%.

The 1970s date is important because this is when fiat currency, not anchored by any hard asset value, was first introduced. It is at this point that Deutsche Bank notes financial crisis frequency meaningfully increased, putting the economy at risk today. “We think that the post Bretton Woods (1971-) global financial system remains vulnerable to financial crises.”

Looking at correlation statistics throughout history, the report concludes “a higher number of crises/shocks coincide with higher levels of debt,” a problem that exists today. High levels of government debt have gone from an emergency feature during wartime to “now a permanent feature.”

When attempting to predict the next crisis trigger, a challenging endeavor that takes the “surprise” out of the equation, Deutsche Bank nonetheless pushes ahead by touching on common themes. This includes central banks unwinding historic quantitative easing, Italy and China – both highly leveraged economies – as well as global imbalances at elevated levels, the rise of populism, Brexit, a lack of liquidity, Japan in “a permanent stupor” and the lack of liquidity amid a shifting market structure landscape.

China might be the biggest trigger for the next financial crisis as many others have warned, Deutsche Bank incorporates new data from the IMF to present a dark picture, the analyst opine:

Perhaps the most striking take away from the IMF’s latest report was their analysis that in 43 global cases of credit booms in which the credit to GDP ratio increased by more than 30 percentage points over a 5-year period, only 5 cases ended without a major growth slowdown or financial crisis immediately afterwards. The IMF also caveated that these 5 cases, considering country specific factors, provided little comfort. If that wasn’t enough, the fund also points out that all credit booms that began when the ratios were above 100% ended badly.
The warning signs are there and the fundamental vulnerabilities remain. The greater issue might be ‘when’ rather than ‘if’ the credit bubble pops. The burden has seemingly been passed from government to government and with another leadership reshuffle due at the end of the year we’ll see if the problems again fail to be fully addressed. China isn’t faced with a new story but you could argue that the relevant stress indicators are now at levels where global history suggests there are no smooth rebalancings.

A picture is worth a thousand words they say. Here is  DB's chart on China's massive debt build up, noting later in the report that "The prospect of the property market bubble bursting is very real" among other internal catalysts for a Chinese financial crash.

Others are less concerned about China - see here for just one example.

A financial crisis is a fact of life; the issue might not be ignoring the elephant in the room but planning for its inevitability.

The bank notes the cause of all this started a long time ago and is not just a recent phenomenon, they opine:

Over the course of the last 45 years financial market regulation also progressively loosened allowing private sector institutions to create money in a manner never previously seen on such a scale through history. A combination of fiat currencies and ever weakening financial market regulation basically ensured exponential growth in credit and debt creation.

 

If there is a  " next financial crisis " as bad as DB proposes, the returns will be brutal for almost every asset class.

While the forecast is dire, it is important to note again that many calls have been wrong over the past eight years.

In the end, no one knows what will happen next. The only thing an individual can do is hope for the best and prepare for the worst.