The prevalent opinion among most financial and economic analysts is that the global economy would be facing a major crisis in the foreseeable future. Admittedly, this bleak forecast has been around at least for the past two years. But some still believe this time around it will be different as we have taken on board the lessons of what caused the last financial crisis of a decade ago.
What will cause the next financial crisis is difficult to predict. Usually the weaknesses that bring about a crisis are either not evident enough in the initial stages or are misdiagnosed by experts. However, there are some indications of the high-risk factors that can make the next crisis much more painful for investors.
The low-interest-rate regime that central banks have sponsored to stimulate economic growth has caused some collateral damage that has mainly affected small investors. Many people are assiduous savers because they still believe in the value of frugality to build a retirement pot. This habit will hopefully see them preserve their quality of life in retirement. But their search for yield can put their financial health at risk. The insensitivity to world events, the minimal returns provided by banks and investment-grade bonds, and the lack of understanding of the price of risk expose small investors to the likelihood of substantial wealth destruction. Put in another way, in an environment of low yield, investors shift towards riskier investments in search of higher returns.
The risk of small investors continuing to be insensitive to the threats of economic growth in Europe is very real
This search for yield often leads to what may appear as benign trading conditions as investors use any dip in prices to squeeze as much additional yield as they can from financial markets. Even traditionally conservative investors who shun putting their money in equities are often not thinking twice before putting their life savings in the high yield junk bond market.
The local scenario is even more worrying. Many corporate borrowers are increasingly bypassing banks for their financing requirements. They go directly to the bond market to get the money they need for their projects. All kinds of local bond issues are almost invariably oversubscribed. This phenomenon is viewed by those who suffer from financial myopia as a sign of success. The more plausible assessment is that many investors who have little understanding of how to price risk are sleepwalking in a potential disaster that could see their wealth destroyed.
So far, we have not experienced a significant bond issuer default. But this is bound to happen. When it does happen, many small investors will be hurt, and the bond market will be spooked. What adds to this nightmare scenario is that some of these bonds are issued to finance speculative projects relating to residential and commercial property development.
Of course, no two economists agree at what stage we are in the cycle of the property development industry. Some have a vested interest in talking up the market because their livelihood or the fulfilment of their personal ambitions depends on a market keeps frothing and is oblivious of the boom and bust cycles that inevitably recur in every industry.
With interest rates likely to remain low for the next two years, the risk of small investors continuing to be insensitive to the threats of economic growth in Europe is very real. With market volatility declining because of policy interventions by the ECB, investors become more convinced that this is a benign environment. These investors are more willing to use market dips to build positions.
Consumer protection regulators are hardly doing enough to warn investors about the risk of viewing investment opportunities purely on the promised return in corporate borrowers’ prospectuses. The legal wording of prospectuses is impeccably drafted to defend the borrowers’ interests if and when a business goes under. But is this what the duty of care to uninformed investors should be?
When every Pawlu, Ċensu and Salvu start to believe they can realise their dream of becoming rich by knocking down their terraced house and entrust a contractor to build four apartments in its place, then you start to wonder when this illusion will turn into a nightmare.
It is not just banks that need to de-risk their business model because the money they use to grow their business comes from retail depositors. Businesses who depend on small investors to finance their speculative projects should do the same.
Ultra-easy monetary policy exposes investors with low risk tolerance to the real possibility of wealth destruction as they desperately search for yield.