PROFESSOR ALAN BECKENSTEIN
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The Consequences of an Overheated Economy
“I see a 50 percent chance of a U.S. recession in the second half of 2019, depending on how fast the Federal Reserve raises the cost of borrowing money,” says Professor Alan Beckenstein, who teaches in the Global Economies and Markets area at Darden. The problem Beckenstein sees is that the U.S. economy has been expanding at an unsustainable rate and interest rates are rising. Those two things together have the potential to shock the economy into a recession, he explains. If the rate hikes are slower than expected, then a recession could come later. Even before the Trump administrationbacked tax cuts, the U.S. economy was booming. The tax cuts added fuel to an already roaring fire, Beckenstein says. “Who thought we’d have an expansionary fiscal policy at full employment?” As the economy accelerates, and the Fed wishes to prevent inflation from rising, interest rates will rise faster than previously expected, and that will cause the price of bonds to tumble, possibly quickly and significantly. Many small and large investors own bonds. Such a bond-market drop could cause a “negative wealth shock,” meaning bondowners could feel poorer and close their wallets — potentially sending the economy into a recession.
For more insights from Darden faculty and industry experts on the economy and 2008 financial crisis, see coverage of the 2018 University of Virgina Investing Conference at news.darden.virginia.edu.
DEAN EMERITUS AND UNIVERSITY PROFESSOR BOB BRUNER
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Ripples From Global Currency and Commodity Shocks
Last year’s surge in the value of the U.S. dollar and resulting fall in some emerging market currencies also has the potential to cause a crisis. “Very great stresses are associated with currency declines,” says Dean Emeritus and University Professor Bob Bruner, who has studied past financial crises extensively. Falling commodity prices can create a similar crunch, he says. “The panic of 1837 resulted from sharp movements in the price of cotton, and the panic of 1857 was caused by the plummeting price of foodstuffs after the Crimean War in 1856,” he says. “These are very interesting stories because the shock often occurs well before the crisis.” Some countries experienced an economic shock in 2018. As the greenback rallied last year, money fled emerging economies in favor of the U.S. The result for some countries was a brutal crash in the value of their currencies. The Turkish lira and Argentinian peso were two of the worst hit. Other nations saw their currencies weaken as well. Many such countries borrowed money denominated in dollars, Bruner says. Massive currency depreciation means that the costs of paying the debts spiral up when measured in local currency. Put simply, some countries went from swimming in debt to submerged in it. However, a larger problem would come if these countries stop paying the banks that lent them money. That would hit profits at the financial institutions and could also hurt anyone who loaned money to those banks. That’s how the crisis in 2007 spread across the world: from bank to bank to bank. Bruner cautions that this doesn’t mean the global financial system will grind to a halt. “I don’t think the financial system is anywhere near as vulnerable as it was in 2007,” he says. However, it could cause banks to lend less freely.
PROFESSOR RICH EVANS
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Exchange-Traded Funds in Uncharted Territory
A financial innovation that came of age over the last decade has the potential to exacerbate a fall in stocks. In other words, a dip in the S&P 500 might quickly morph into a plunge. “I am concerned about how exchange-traded funds (ETFs) perform when we finally have a down market,” says Professor Rich Evans, who teaches about investments and portfolio management. ETFs are unique in that they hold diversified securities, like mutual funds, but are bought and sold on an exchange, like stocks. Use of ETFs has exploded since the financial crisis. Globally, there are now more than $5 trillion of assets in ETFs, according to the website TrackInsight, up from under half a trillion in 2005. The enormous volume concerns Evans because the way these securities trade is not the same as individual stocks, which could leave investors without an easy way to buy or sell their ETF shares. Here’s how: ETF dealers make money off the difference between the price at which they buy and sell shares. Ideally, ETF dealers end each day having bought and sold the same number of shares. That way the dealer profits regardless of whether the market rises or falls. But sometimes there’s a mismatch. For instance, a dealer may sell far more shares than it had available to send to customers. In this example, the ETF dealer should create more shares. However, Evans discovered that sometimes dealers don’t do that. Instead, they wait days to create those shares and, in doing so, increase their effective leverage, running the risk of losing money or even going bust if the stock market swings the wrong way and they are not fully hedged. Because of the huge total net assets invested now in ETFs, this could potentially exacerbate a market nosedive. WINTER 2019
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