JPMORGAN: Here's what could cause the next financial crisis

JPMorgan has already coined a nickname for the next financial meltdown.

And while the firm isn't sure exactly when the so-called "Great Liquidity Crisis" (GLC) will strike, it figures that tensions will start to ratchet up in 2018, once the Federal Reserve starts to unwind its massive balance sheet.

If a reversal of unpredented monetary easing does, in fact, spur a market crash, it would be cruel twist of irony. After all, it was that same stimulus that helped rescue global markets from the abyss back in 2008, when the last crisis hit.

Speaking of that meltdown, JPMorgan is quick to point out that it too was caused by a collapse in liquidity. Except that time, the squeeze was catalyzed by banks underwriting mortgage-backed securities that turned out to be lethal for the market.

Different cause, potentially same crushing result.

"The timing will largely be determined by the pace of central bank normalization, business cycle dynamics and various idiosyncratic events, and hence cannot be known accurately," Marko Kolanovic, JPMorgan's global head of quantitative and derivatives strategy, wrote in a client note. "This is similar to the 2008 global financial crisis (GFC), when those that accurately predicted the nature of the GFC started doing so around 2006."

JPMorgan highlights several specific market developments that have transpired to potentially create "severe liquidity disruptions":

1. Decreased assets under management of strategies that buy value assets - "The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns," says Kolanovic.
2. Tail risk of private assets - "Outflows from active value investors may be related to an increase in private ... Private assets reduce day-to-day volatility of a portfolio, but add liquidity-driven tail risk. Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis."
3. Increased assets under management for strategies that sell on "autopilot" - "Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking. A market shock would prompt these strategies to programmatically sell into weakness."
4. Trends in liquidity provision - "In market making, this has been a shift from human market makers that are slower and often rely on valuations, to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking. This trend strengthens momentum and reduces day-to-day volatility, but increases the risk of disruptions."
5. Miscalculation of portfolio risk - "Over the past 2 decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail."
6. Valuation excesses - "Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology- and internet-related stocks.

So where does this leave the market right now? After all, the S&P 500 is fresh off new record highs, and earnings growth - long viewed as the backbone of the 8 1/2-year bull market - is still going strong.

Kolanovic has no issues with it, at least yet. He readily admits that conditions are fine, and that gains have been backed by optimism over tax reform and a stock market rotation at the sector level.

He's more concerned about the dangers lurking in the shadows of the market - the hidden risks outlined above, which have created what he views as an increasingly tenuous situation beneath the surface.

"With the upcoming positive Q3 earnings season, uptick in global growth, promise of tax reform keeping fundamental funds invested, and low volatility keeping systematic strategies invested, near-term risks of a sell-off have abated," said Kolanovic. "However, these positive developments may prompt central banks to proceed with normalization, setting the stage for the end of the cycle."

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