What Will Cause the Next Financial Crisis? J.P. Morgan Says ‘Liquidity
As the 10th anniversary of the financial crisis approaches, J.P. Morgan Chase & Co’s Marko Kolanovic says the next one will be brought about by a liquidity crunch.
Following the 2008 financial crisis, central banks purchased $15 trillion of assets. Now, that accommodation is starting to reverse as central banks pull back from their actions over the past decade, like keeping interest rates near zero or making purchases in markets.
This process of “central bank normalization” could lead to declines in asset prices and disruptions in market liquidity, according to Mr. Kolanovic, the global head of macro, derivatives and quantitative strategies at J.P. Morgan. He dubbed the hypothetical scenario the “Great Liquidity Crisis.”
Essentially, he sees the reactions and developments to the 2008 crisis being partly responsible for causing the next one. The last crisis changed the way the market can prevent and rebound from significant slumps and withdrawals of money from markets, he wrote.
One of these developments was the massive shift from active investing to passive funds. About $2 trillion has rotated from active strategies to passive and momentum strategies, Mr. Kolanovic wrote.
That’s reduced the ability of so-called “value investors”–those who buy when asset prices are cheap–to swoop in during selloffs.
The shift “eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption,” he wrote.
There’s also been a flood of money into assets like private equity, real estate, and illiquid credit holdings, Mr. Kolanovic wrote. This has damped the daily volatility of investors’ portfolios while magnifying the chance of a “liquidity-driven tail risk” because such assets are harder to trade in and out of. They can be disrupted for far longer during a market crisis, he wrote.
Another hazard is the strong growth systematic strategies have seen. These strategies rely on momentum and asset volatility to gauge how much risk should be taken. In a market shock, such strategies would “sell into weakness,” he wrote. For example, futures-based strategies have grown by about $1 trillion, and the potential impact on volumes from options-based hedging strategies have increased from three days to seven.
Investor risk models are based on bonds balancing out the potential risks from stocks. This could backfire, according to him.
Mr. Kolanovic also ventured into areas such as artificial intelligence and cryptocurrencies, pointing to initial crypto-coin offerings and high valuation for smartphone applications as signs of excesses in current markets.
His predictions comes as U.S. stock markets are bucking seasonal volatility trends. One measure of market volatility just recorded its calmest quarter on record.
Investors shouldn’t conflate low volatility for low risk, according to Mr. Kolanovic. Sometimes expensive assets don’t record large swings but could be quite risky, he said.