JPMorgan has established a blueprint for the next big market crash - and warns it could create the biggest social conflict in 50 years

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JPMorgan has established a blueprint for the next big market crash - and warns it could create the biggest social conflict in 50 years

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Reuters / Scott Olson

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  • JPMorgan's global head of quantitative and derivatives strategy, Marko Kolanovic, lays out his template for the next big market crash.
  • Kolanovic attributes the dangerous conditions currently facing markets to seven key developments since the 2008 financial crisis.
  • He even goes as far as to make a dire prediction about how a negative market event will affect social harmony.

An idealistic follower of financial markets might tell you that we learned our lesson following the crisis that rocked the globe a decade ago.

Banking regulations were ramped up to prevent the type of risky behavior that doomed markets, and investors have repeatedly been warned to check their euphoria this time around.

But a new report from JPMorgan suggests that - despite our best efforts - we're hurtling towards a similarly painful reckoning.

And once again, a familiar foe is working against harmonious market conditions: a lack of liquidity.

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Back in 2008, banks underwrote real-estate products with exorbitant leverage. Then, the subsequent liquidity crunch in these same instruments decimated balance sheets across Wall Street.

This time around, the surrounding conditions are different, but investors face a similar lack of capital maneuverability. This prospect is so dire, in fact, that JPMorgan has named its market-crash blueprint after it - the "Great Liquidity Crisis" (GLC).

"The main attribute of the next crisis will likely be severe liquidity disruptions resulting from market developments since the last crisis," Marko Kolanovic, JPMorgan's global head of quantitative and derivatives strategy, wrote in a client note.

The developments fueling the fire

So how exactly does the market's current liquidity conundrum differ from the mortgage-driven meltdown 10 years ago?

Allow quant guru Kolanovic - whose opinions are valued so highly they can move markets - to break down the seven reasons we're in this situation. When combined, these market attributes solidify the backbone of Kolanovic's crisis template.

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(1) The shift from active investing to passive strategies

JPMorgan notes that the exchange-traded fund (ETF) market has swelled to $5 trillion globally, up from $800 billion in 2008.

While this is great news for the providers of these ETFs, it's actually made it more difficult for the market to prevent and recover from periods of weakness.

"The ~$2 trillion rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption," Kolanovic said.

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JPMorgan

(2) The increasing amount of assets managed by strategies that sell on "autopilot"

So-called passive investment vehicles pose a problem to market efficiency, since they often operate in price-insensitive fashion. As they've increased in popularity, they've subsequently rendered traditional measures of valuation moot.

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Kolanovic's specific beef stems from these strategies' reliance on momentum and asset volatility to determine a level of risk-taking.

"A market shock would prompt these strategies to programmatically sell into weakness," he said.

In other words, they make bad situations even worse.

(3) Changing market-making trends

Kolanovic argues the increased reliance on programmatic market makers has increased the risk of widespread disruptions. He says it's affected the depth of major indexes like the S&P 500 during turbulent periods, since those passive entities rely more on volatility targeting than valuations.

"This trend strengthens momentum and reduces day-to-day volatility, but it increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014, and August 2015," Kolanovic said.

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(4) Miscalculation of portfolio risk

Throughout history, bonds have represented a safe hedge against equity-market weakness. When the going has gotten tough in stocks, investors have simply rotated into fixed income.

But Kolanovic says this dynamic is fading due to low interest rates and massive central bank balance sheets, which combine to make bonds less appealing by comparison.

He also argues volatility is an inexact measure of portfolio risk, especially when used by itself.

"Very expensive assets often have very low volatility, and despite the downside, risks are deemed perfectly safe by these models," he said.

(5) Private assets carry great liquidity risk

Kolanovic notes that, over the past 20 years, the money allocated to public equity has declined, while holdings of private assets have increased. He finds this problematic.

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"Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis," he said.

(6) Exorbitant valuations

This is perhaps the most straightforward of Kolanovic's arguments. Simply put, valuations are historically extended. And even though traditional measures of price-to-earnings have come down, risks still persist.

"Following the large U.S. fiscal stimulus, strong earnings growth reduced equity valuations to long-term average levels," he said. "Despite more reasonable valuations, equity markets may not hold up should monetary tightening continue, particularly if it is accompanied by toxic populism and business disruptive trade wars."

(7) The rise of protectionism and trade wars

Speaking on that last topic, Kolanovic offers the following:

"The great risk of trade wars is their delayed impact. The combination of a delayed impact from rising interest rates and a disruption of global trade have the potential to become catalysts for the next market crisis and economic recession."

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The worst social tensions since 1968

Going beyond the finance-specific ramifications of a liquidity crisis, JPMorgan has also assessed the societal impact. And its takeaways are far from reassuring.

The firm equates the rise of the internet and social media to the type of TV reporting and investigative journalism that stoked political debate around the Vietnam War.

"Similar to 1968, the internet today provides millennials with unrestricted access to information on a surprisingly similar range of issues," Kolanovic said. "In addition to information, the internet provides a platform for various social groups to become more self-aware, polarized, and organized."

It's that last mention of polarization that really drives home JPMorgan's point that social tensions will likely rise in the event of a crash. After all, they previously reached a fever pitch in the US after President Donald Trump's election victory, and in the UK after the Brexit vote.

In the end, if severe turmoil hits, all bets will be off - and it's bound to extend far further than markets.

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