Written By: Steven Winter – Corporate Finance
Are you prepared for the next global financial crisis? Analysts at the Royal Bank of Scotland are warning of a looming stock market crash and a severe global recession by the end of this year. Albert Edwards, a strategist at Societe Generale, a French investment bank, believes that we are heading toward the worst economic turbulence since the Great Depression of 1929. The warnings come as the world stock and commodity markets have continued to experience high volatility since mid-2014. While most analysts have their eyes set on the unhealthy fluctuations in stock and housing markets in the United States and China, another massive wave is building up in the commodity markets. Since August last year, crude oil has taken a nosedive from $115 per barrel to a rock bottom of $27 at the beginning of 2016. Even when the prices rebound, the current glut in the market will not allow them to go beyond $60 per barrel anytime soon.
Under normal circumstances, the fall in crude oil prices should be something to celebrate for net importers of oil and for individual consumers. However, the effects of the recent plunge on the growing debt in emerging markets have left strategists wondering if the world economy is sitting on a ticking time bomb.
The United States is part of it but not on the front line.
In the United States alone, Bloomberg has estimated that there were more than $19 billion in junk-bond defaults in the first two months of plummeting oil prices. As of April 2016, Energy Information Administration research indicated a $67 billion loss by the US oil companies operating onshore. The hardest-hit companies are those that accumulated debts during the shale boom.
According to James Hamilton, an editor at Econbrowser, the striking correlation between falling oil prices and the declining US stock market is a clear indication of systemic risk. The dip in the stock market on the news of falling oil prices shows that investors are taking it as bad news.
Across Wall Street, the firms that jumped on the oil boom with two feet are now on shaky ground as oil debts continue to turn sour. In May this year, the Bank of America Merrill Lynch announced that it will be setting aside $997 million as protection from losses in its energy portfolio. Wells Fargo and JPMorgan Chase have followed suit by increasing their provisions for credit losses in their energy portfolios, attributing their actions to the significant stress caused by volatile oil prices.
Dick Bove, an equity research analyst at Rafferty Capital, says that even though the fall in oil prices is hurting big banks in the United States, there is little risk of it causing a meltdown. However, the risk is magnified when the problem is coupled with other fallouts in the global economy.
The oil-price crisis poses a greater risk in emerging markets.
In the emerging markets, oil drillers are struggling to stay afloat as profitability declines and the payments on their syndicated loans mature. Moody’s Investors Service has warned that weak oil and commodities prices will drag down not only the economies of the emerging markets but the entire global financial system.
These countries are almost going bankrupt, with the majority of them turning to the West for financing to cope with their budget deficits. Venezuela is already in its worst recession on record, while Russia, Nigeria and Brazil are having difficulties financing their public deficits. In Saudi Arabia, the government is implementing austerity measures in an effort to reduce its budget deficits as its revenues decline with falling oil prices. The International Monetary Fund (IMF) predicts that under the current circumstances, Saudi Arabia will go bankrupt by 2020.
While slowed economic growth is a catalyst to the global financial downturn, it is not the number one reason we should be worried.
Russia may be a key player.
Analysts at Wells Fargo believe that if oil prices continue to plummet, Russia will default on its $660 billion corporate bonds, of which $160 billion is denominated in foreign currency and held by investors in Western Europe. Even though a portion of this debt has been cleared with the help of the country’s foreign reserves, there is still fear that the country may fail to meet its obligations on future payments. If Moscow defaults on these corporate bonds, there is a likelihood that a recession will be accelerated in the already strained European economy. The fall of European banks could mean the systemic risk that triggers the looming global financial crisis.
European banks are already under siege.
While the drop in oil prices is a good thing for the deflation and slow economic growth in the European economy, the massive investments made by European banks in the oil and commodity sectors during the boom have started going sour. Banking stocks are in a freefall as investors fear that the slow recovery of oil prices may lead to massive defaults.
Big banks such as Deutsche and Credit Suisse are already on fire as their provisions on nonperforming loans skyrocket, and the costs of insuring debt become unmanageable.
Analysts are predicting that if the overleveraged Deutsche Bank fails, the effects on the global financial system may be three times that of those experienced after the collapse of Lehman Brothers. Apart from the slide in oil prices and the rise of nonperforming loans, the situation has been worsened by bad publicity after the bank has been accused of rigging the precious-metals market.
The reliance of European banks on risky trading revenue is to blame for their vulnerability to the fall of the global oil and commodity markets. The exposure of these banks to energy-sector loans is estimated to be in excess of $100 billion dollars, thus giving them no option but to raise capital ratios to offset the troubled loans.
The Chinese commodity futures market will initiate the collapse.
In China, the fall of steel, coal and iron-ore prices has left investors with the jitters over losing their huge bets in the industry. According to Mitchell Hugers, a commodities analyst at BMI Research, the slowing Chinese economy is to blame for the declining demand for steel, copper and iron ore. The excess speculation in the market has further increased the volatility of commodity futures, hence exposing the global financial system to the risk of collapse.
Even with the rebound in prices and the introduction of measures to curb speculative commodity trading, there is still a higher risk of a bubble burst given past exposures. Also, the failure of the Chinese government to control its debt would mean only a financial collapse in the event of a further decline in its manufacturing sector. George Soros has warned that China is on the verge of an economic downturn, and it will drag the whole world along. From the look of things, if the Chinese commodity market is going to crash as analysts predict, it will be the beginning of one of the major global financial disasters of our times.