A different world since the Global Financial Crisis
We use the 10-year anniversary of the Global Financial Crisis (GFC) as an opportune time to evaluate the current market backdrop and identify where the next serious correction could potentially come from. As a recap, the root cause of the GFC stemmed from the spectacular growth in US house prices prior to 2008. This encouraged borrowers and investors to take more risk through increased leverage, at a time when lending standards were lax and risk controls were poor. To make matters worse, global financial institutions used short- term funding from money markets to facilitate the expansion of long-term assets (i.e. mortgage backed securities) on their books, thus creating a maturity mismatch. When investors feared the US housing market was turning down, they began to sell their mortgage-backed securities. This reduced the value of these illiquid assets held on banks’ balance sheets and cumulated in the failure of Lehman Brothers as it ran out of cash and could not remain a viable business. In other words, the GFC started off as a credit crisis, but eventually morphed into a liquidity crisis.
The impact of the GFC on the market can be split into two distinct phases. The US S&P 500 benchmark index fell 24% from a peak on the 9 October 2007 to the Lehman’s bankruptcy on 15 September 2008. Investors then panicked after Lehman’s collapse and US stocks fell a further 45%, before finding a trough in early 2009. The reason behind the market panic lay in Lehman’s role as a clearing house and repository for many thousands of financial instruments. When Lehmans went bust, it was not clear which financial institutions were exposed or whether trades could be cleared/ hedged. Moreover, by failing to bailout Lehman, while supporting other financial institutions like insurer AIG, the US government confused market participants. This uncertainty led to a near seizure in credit markets and a sharp decline in investor confidence that spread globally. The GFC finally stabilised after a massive coordinated global response by global central banks, including Quantitative Easing (QE), rate cuts and theprovision of Fed lines of credit to US and non-US banks, as well as countercyclical fiscal stimulus.
Turning to today, the market backdrop is vastly different than prior to the GFC. First, business investment has lagged the economic recovery. Less investment has enabled corporates to save more cash for share buybacks or park funds in bank deposits and money market funds, which have been used by banks to keep fixed income yields down. Second, unconventional monetary policy (i.e. QE) is here to stay and acts as a liquidity tool to prevent a sharp decline in output growth. And third, shifts in the regulatory environment and supervisory frameworks have lowered risks in the financial sector.
Arguably, the key change for major US banks was a more than tripling in capital requirements and a doubling
in liquid assets on their balance sheet compared to 2007. Thus, banks now have a larger buffer to handle unforeseen losses. Banks are also now subject to harsh annual stress tests, less complex and have been
prohibited from using their own accounts for short-term proprietary trading (the so-called “Volcker” rule named after a former Fed Chairman).
Identifying future sources of risks
The unintended consequence of post-GFC policy creates future risks. Post the crisis, global debt is up and this leaves less leeway for future borrowing to fund recovery from the next recession. For instance, back in 2008, China played a major role in stimulating the world economy, principally because it was less indebted. However, with total debt around 300% of GDP, China may not be in a position to pump-prime global growth when the next downturn comes. Moreover, higher debt leaves the global economy vulnerable to interest rate rises.
QE has led to distortions in the market. Credit quality in the bond market has deteriorated as high-yield bond issuers took advantage of record low interest rates to raise debt. Consider Argentina. It has gone from issuing a 100-year sovereign bond to seeking an IMF bailout in just over a year! Such examples of borrowing folly have depressed investor sentiment in the Emerging Market complex. QE policies might also be blamed for contributing to unaffordable house prices and widening income inequality, a fact that has been capitalised on by populist parties on both left and right. President Trump has partly cited the disparity in wealth as a reason to advance his trade protectionist agenda, a move that could tip the world into a trade/economic war and make a coordinated response to another potential financial crisis more difficult.
And finally, the next crisis could be driven by severe liquidity disruptions in financial markets from the rise in passive investing (a strategy that tracks benchmark indices) over active investing (fund management).
Specifically, the switch away from active value investing lowers the ability of the market to recover from a sizeable drawdown, since a decline in equity values may induce more selling as passive funds track indexes lower.