Crisis Indicators

Ever wondered that even financial crisis can make you a billionaire? Well, I recently watched one of the best movies on 2008 financial crisis – “The Big Short.” You won’t believe they made billions of dollars of money during the crisis because they knew what was coming. They knew the crisis indicators!

Crisis – A critical point of time leading to a very unstable and difficult situation.

Crisis indicators – They help you determine the phase you are about to enter. However, uncertainty cannot be factored into any analysis.

There are various indicators observed before the crisis. According to one of the research paper, so many factors help you determine the same. Here is one of the research which states variation in individual indicators explaining the impact of the crisis on the real economy.

Source – https://pdfs.semanticscholars.org

But broadly, let us focus on four such indicators and its correlation to the current scenario:

1. High Debt: First indicator of an economic crisis is generally seemed to be the crisis of debt. The debt crisis is a situation when one loses the ability to pay back debt which results in loss of financial capital. Such non-repayment of debt turned to be the epidemic during the 2008 global financial crisis along with other reasons such as risky lending in the sub-prime mortgage market and extremely leveraged derivatives trading on Wall Street.

2. Bond Market - Inverted Yield Curve. So generally, the long term bonds have a higher yield than the short term ones. The game starts reversing when short term bonds start offering higher yield than long term bonds. This is not because the investors have faith in short term bonds but rather, the demand for short term bond is too low that it must offer higher returns. This happens because investors lose faith in short term returns and demand for long term bond increases as they do not have to offer any high yield. The bond market phenomenon is historically a trusty signal of an eventual recession since it has preceded the seven last recessions. Also, according to Credit Suisse, a recession occurs about 22 months after the inversion of the yield curve. And to our very surprise, in August 2019, 2-year’s US Treasury yield was at 1.614%, above the 10-year at 1.611%.

3. Market capitalization ratio to GDP - This the single best measure for market valuation in share market compared to the real economy. To simply put, the market cap of all equities surpasses the value of GDP. You must be thinking that it’s the bull sign as equity seems attractive and investors expect a brighter future. But wait, there is a point where perception exceeds reality and this is what happened during the 2008 crisis as well. The ratio hit a peak of 149% in December 2007 during the 2003-08 bull-run. However, currently, the market-cap-to-GDP ratio has declined swiftly – from 79% as of FY19 to 56% (FY20 GDP) – much below the long-term average of 75%.

4. High unemployment - In my personal opinion, high unemployment rather than being an indicator, it is the foremost effect of any crisis. As we approach the beginning of the crisis, many people lose jobs. During the 2008 global financial crisis, nearly 8 million people lost their job just in the US. Globally, the unemployment rate increased to 5.6% in 2008 from 5% in 2007. Currently, global unemployment is projected to increase by around 2.5 million.

Future is totally uncertain. But history tends to repeat itself.

There is a wonderful saying, you can only connect dots looking backwards, what’s coming and why it’s coming can only be known once it’s done. That doesn’t mean today has no impact on tomorrow. Future is definitely dependent on the outcome of the present. Thus, observing the economy at the macro level with the help of such indicators, one can surely determine the phase we are about to enter.

Write-up by: Shaili Shah