Did we just feel the warning tremors of the next financial crash?

Last week, tremors that had been rumbling through the financial markets since the turn of the year came to the surface.

Last week, tremors that had been rumbling through the financial markets since the turn of the year came to the surface.

The New York stock market dropped over 2 per cent on Friday and the Tokyo stock market fell 2.5 per cent on Monday, dropping 8 per cent in three days. The Argentinian currency, the Peso, fell by 15 per cent in a day and was quickly followed by the currencies of Turkey, Brazil, South Africa, India and Russia.

The reason behind this fall was that three big economic stories of the last few years were unravelling into one: China, shadow banking and Quantitative Easing (QE).

On Friday, a Chinese trust investment fund with the descriptive name ‘Credit Equals Gold No. 1’ – a half a billion dollar fund – appeared to be on the verge of defaulting, but after immense volatility a deal with those originally refusing to bail it out was done.

Whether this is seen as satisfactory the damage has been done in exposing the dangers related to the Chinese shadow banking system which consists of $4.8 trillion, according to Moody’s, of undeclared risk – equivalent to half of Chinese total GDP. And to those who believe the trouble has passed, Kevin Lai, an analyst with Daiwa Capital Markets, had this to say: “We believe recent trust troubles in China are only the tip of the iceberg”.

When coupled with the fact that it was the weakening of the Chinese economy that has exposed this risk the similarities to Lehman Brothers and the US in 2007/8 have, to quote George Soros, “eerie resemblances”.

We are now also seeing the real effects of the slowdown of QE by the US Federal Reserve. We have long been aware that QE was landing on “Wall Street” and not “Main Street”, with cheap money moving into asset purchasing of both shares and riskier investments. With the US recovering and the developing world faltering, in particular in the wake to Chinese growth fears, this money is going home to the US in a big way – the emerging markets have suffered 13 weeks of negative capital outflows from their countries.

What this means for the developing world in the short run is a currency crisis, but may soon become a full on credit crunch, meaning investment, the life blood of development, going into reverse.

That developed countries will come out of this unscathed is debatable, with QE causing shares to ‘melt up’; stock markets are overpriced by almost all indicators; the respected Shiller CAPE index shows earnings to price ratios nearing 2007 pre-crash levels (see chart).

Black Tuesday-JPEG

With companies in the UK issuing record profit warnings rather than record profits, the likelihood of companies reaching a decent price to earnings ratio without a large price correction seems unlikely.

The self-fulfilling prophecy of markets is also a well-known factor: it was only a month ago that Goldman Sachs advised clients to reduce emerging markets assets by a third, which now is looking clever, but may also be seen as clever manipulation of the market.

All of us who see markets as imperfect will know that predictions of the future of the market can never be sure: Chinese intervention on shadow banking or a Federal Reserve increasing QE spooked by market reaction could mean any correction is years away.

However, we do seem to have had a glimpse of where the tectonic plates of the world economy are shifting and where future pressure points may lie. That these are the same pressure points which were exposed in 2007 is depressing, but how a still fragile global economy will cope with another financial crisis is the real worry.

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