The Next Financial Crisis Is Unfolding Now

Money Morning Members should know two things. First: the 2008 financial crisis was caused by a housing bubble, centered in the United States, that radiated out through the rest of the world and almost destroyed the global financial system.

Second: The next financial crisis - which is starting to unfold as we speak - was caused by a commodities bubble centered in China that radiated out through the rest of the world and will cause enormous financial damage, threatening the global financial system.

Both crises were aided and abetted by central banks printing massive amounts of debt that can never be repaid. That leaves the world with three choices for how to deal with that debt - currency depreciation (which is why you should buy gold), inflation, and default.

There is one crucial difference between the current Super Crash and the last one - today there is much more global debt (roughly $200 trillion and rising) and the geopolitical landscape is much less stable than it was seven years ago. This means that today's world is much more fragile than it was seven years ago. It's crucial to acknowledge this reality and move to protect your investments immediately, if you have not already done so. Much more pain is in store.

High-Yield Debt Is Returning to Crisis Levels

The low-light of last week's market was the continuing collapse of the high-yield bond market. This market is experiencing a crash that is every bit as bad at 2009, when spreads blew out to 2,500 basis points. While the headline numbers are nowhere as bad as that yet, under the surface market internals are moving in that direction and could easily get that bad.

The average yield and spread on the Barclays High Yield Index were 8.4% and 635 basis points on Friday morning. But sectors like energy and basic industry were at 14% and 1,200 basis points (and many individual bonds are trading at much worse levels). These levels did not yet reflect the market's reaction to the unprecedented announcement by Third Avenue Management LLC that it was liquidating and restricting redemptions in its $789 Third Avenue Focused Credit Fund - a mutual fund that has lost 27% year to date.

Nor did they reflect the news that a $400 million distressed debt fund managed by billion dollar Stone Lion Capital Partners LP was also restricting redemptions. These funds are telling investors they can't give back their money because it is virtually impossible to sell bonds in today's highly illiquid junk bond market at a reasonable price (if at all).

Bond trading on Friday was frozen as reflected in large high-yield bond exchange-traded funds (ETFs). The iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG) dropping 2 points to close at $79.52 - its lowest price since July 2009 - on a record 53 million shares. CCC-rated bonds are trading at yields and spreads of 16% and 1,400 basis points and will no doubt widen further as whatever little liquidity exists in this sector of the market continues to evaporate.

Large hedge funds, mutual funds, and ETFs stuffed with billions of dollars of these bonds are in for a miserable time over the next couple of years. Lower prices and illiquidity will raise the cost of capital for leveraged companies to levels that will force many of them into bankruptcy.

On the other hand, investors who can serve as liquidity providers over the next couple of years will make out like bandits. Anybody who didn't see this coming hasn't been paying attention. Readers of this column and Sure Money should not be surprised by any of this.

Stocks took it on the chin last week and saw their biggest losses since last August. The Dow Jones Industrial Average dropped 582 points or 3.3% to 17,266.21, while the S&P 500 lost 3.8% to end at 2,012.37. The Nasdaq Composite Index fell by 4.1% to close at 4,933.47. Commodity prices continued to fall with WTI crude ending the week at $35.35 per barrel. And bond yields faded a bit with the 10-year Treasury yield settling back at 2.14% (although the two-year was still up at 0.88%).

While the headline, cap-weighted indices are showing little damage for the year, under the surface the markets are experiencing a stealth bear market. Certain sectors like energy and commodities are living through a historic crash with many stocks down 80% or more. The news this week that energy bellwether Kinder-Morgan Inc. (NYSE: KMI) was cutting its dividend by 75% shook the markets. But more energy companies will have to follow KMI's lead if they want to survive what is likely to be a multiyear period of oil prices below $50 per barrel.

The Fed's "Catch-22"

The question now is whether the Fed will still go ahead with a 25-basis point hike next week in the face of collapsing financial markets. A Fed hike in the face of plunging commodity and credit markets would be an unprecedented move. But the Fed has painted itself into a corner with its failed policies and endless jibber-jabbering about its intentions.

The current situation is an object lesson in why the Fed should talk less. Actually, it is an object lesson in why the Fed should be closed down (but that's a discussion for another day). If the Fed were to chicken out now and fail to raise rates by a paltry 25 basis points, it would likely spook markets and send them into an even worse tailspin than they are already in.

That suggests that the Fed will most likely stick to its plan to raise rates for the first time in nearly a decade, but there is no way to predict how markets will react in view of the ongoing sell-off. Either way, markets are in for a rough ride through the next few months because commodity prices and credit market are unlikely to improve.

The "Brave New World" of Activist Investing

Wall Street's disastrous week was appropriately capped by another megamerger by two companies that were forced into each other's arms because they can't generate domestic growth and were too afraid to tell activist investors to go take a hike. Dow Chemical Co. (NYSE: DOW) and DuPont Co. (NYSE: DD) announced a $120 billion merger on Friday that was heralded by The Wall Street Journal in one of the most inane articles ever to appear in the financial press (which is saying something in light of what passes for financial journalism these days).

The article welcomed the arrival of a "new era of activist investing." DuPont had been pressured by activist firm Trian Fund Management LP, headed by Nelson Peltz. And Dow was similarly under the gun from Dan Loeb's Third Point LLC.

Bowing to the alleged influence of these investors forced another late-cycle deal that will lead to tens of thousands of layoffs, lower capital expenditures, and high executive payouts. Yet it accomplishes nothing productive in a bear market. The Journal was too busy licking the boots of billionaires to leave out one key fact: both activist funds are losing money in 2015 and have significantly trailed to S&P 500 (their presumed benchmark) in recent years...

If this is the new age of activist investors, it is an ice age. Their nominal returns are poor and their risk-adjusted returns are terrible. Investors who pay 2% management fees and 20% performance fees to invest in large-cap companies are fools.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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