New article from Tatton Investment Management: Financial crisis – 10 years on

14 September 2018

It was 10 years ago this week that US investment bank Lehman Brothers was allowed to default. This event marked the beginning of the ultimate escalation from a severe credit crunch to a full blown global financial sector meltdown. The shock this caused to businesses led to the worst global recession since the 1930s, the aftermath of which we still experience today, with interest rates and growth rates still not having returned to pre-crisis levels.

To mark this 10th anniversary milestone, reflections pondering ‘could it happen again?’ were aplenty this week. We do not intend to add yet another such article to the pile but would like to provide a perhaps slightly more balanced assessment of where the world of finance differs compared to 10 years ago, where it doesn’t, and what risks and challenges present themselves today.

The most important change we would note is that the years before 2008 were remarkable in their absence of credit fear and domination of financial greed and entitlement. 10 years on and, judging by media coverage, fear or credit driven asset bubbles and repeat collapse of the global financial system remain a dominant theme, while the bull market of the past 9 years is often described as the most unloved in history. Or, for those who have experienced both time periods, it feels like we have gone from exuberant overconfidence that clever financial engineering will forever make everybody a winner in finance to continuous Armageddon paranoia.

The articles this week identified various culprits and causes for the financial crisis without agreement on what single element caused it. It’s not easy to dissect, but just as with other financial crises in history, the common element has always been that capital market participants at some point became convinced that they can only gain and are highly unlikely to ever lose. This leads to excessive risk taking until eventually the proverbial music stops and asset values collapse as there are no longer the prospect of yields or returns that previously perpetuated the upward trend. In the run up to the Financial Crisis, the asset in focus was structured credit securities which had created the perverse incentive to lend ever more to the worst credit risks around without having to apply the scrutiny of traditional credit checks.

Let’s fast forward to 2018. The pessimists will point out that total global credit volumes today are even higher than they were in 2008 and therefore the next collapse is inevitable – as they have prophesied this to happen for the past 9 years. The optimists state that the financial sector has learned its lessons, buffers against losses are back up to what proved historically sufficient, structured credit instruments are now as regulated as banks themselves and credit due diligence and monitoring is once again what it should be.

Our view is that substantial financial crises only repeat once a few generations have passed and the horrors of the last financial melt-down fade from collective memory. Having experienced and worked in the financial sector for the past 30 years, we agree that credit risks are taken serious again. Vast volumes of credit-based finance are not in itself an issue as long as it is backed by activity or individuals that make uninterrupted debt servicing highly likely. Even that is overwhelmingly the case now, but the word ‘now’ is where matters get slightly uncomfortable.

Most loans these days are requiring only minimal interest payments, because rates have been so low for so long. As every householder with a variable rate mortgage knows, should rates double, there will be considerably less money left to spend on other things. Herein lies the risk of today. Not reckless lending as in the early noughties, but an uncomfortable dependence on interest rates not rising quickly. If they did, many households and businesses would have to cut back on their outgoings significantly, which is a sure recipe for an economic downturn.

This provides perspective for Bank of England governor Mark Carney’s remarks this week that a cliff edge no deal Brexit could cause a UK house price crash. Should the central bank have to raise rates drastically to defend £-Sterling (in the event that large amounts of UK capital and savings leave the country for better opportunities abroad and thus drive down the currency’s value), then affordability of mortgages at current house prices would equally drastically deteriorate. This would necessarily require house prices to adjust downwards to levels at which at the higher mortgage payments are once again affordable.

While this particular scenario is very specific to the UK and would not have a similar global effect as the financial crisis did, the general issue is the same. The continuation of the gradual process of economic normalisation that we have enjoyed over the past years hinges disproportionally on a just as gradual an upward normalisation of yield levels. If the increase exceeds the growth in earnings of households and businesses, then the upward trend will be in jeopardy.

Central bankers have done a formidable job in not upsetting this fragile equilibrium through very gentle policy setting. However, this is where politicians need to play their part and refrain from actions which may force central bankers’ hands. A cliff edge Brexit is one example for such a scenario. Turkey and Argentina have already recently provided vivid examples of how badly things can go wrong when politicians disregard monetary and economic necessities.

Herein lies in our view the true issue of our times in 2018. In order to prevent the global economy from descending into a depression as it did in the aftermath of the 1928 financial crisis, the central banks had to support asset values in order to prevent such ultimate collapse. This approach worked – at least when compared to what happened over the course of the 10 years following 1928. Unfortunately, as asset owners have benefitted from the central banks’ remedy, wage growth of the asset-poor working masses and the young generation has suffered.

This in turn has created the deep divisions in western societies that have led to the rise of populism and politicians increasingly acting against the best interests of gradual economic progress, out of fear of being replaced by outright populists.

Where populists have taken political control, central banks may be forced to increase the pace of their rate rises and thereby risk the fragile balance we have progressed under so nicely for the past years. Donald Trump’s pro-cyclical fiscal stimulus through his corporate tax cuts is a case in point. The rush back to the US of US$ capital has already led to a slowdown in emerging markets and disrupted the goldilocks scenario of synchronised growth the world enjoyed in 2017. The supercharging of already healthy growth in the US is beginning to create inflation pressures, which have the potential to lead to rate rises which will be negative for growth, particularly if the US economy has to stomach a double hit from tariff induced trade restrictions.

To end this reflection on not too gloomy a note, as regular readers know, we see a far higher probability for a typical and prolonged EU ‘muddle-through’ approach to the Brexit challenge than a cliff edge scenario in March 2019. Regarding Trump’s lack of macro-economic policy understanding and the interest rate risk this creates, well, let’s say he is inadvertently creating a few counterbalancing headwind forces as well, which may allow the US central bank to refrain from stepping up their current pace of rate rises.

So, in conclusion, 10 years on from the financial crisis, history is unlikely to repeat itself and anybody suggesting as much applies gross simplification to grab headlines. On the other hand, the remedy that prevented the worst back then has created new challenges for today, of which the rising discontent and division of societies on the back of increasingly unequal wealth and income distribution is one that we should take very seriously. As we have stated here before, we’d much rather look back in a few years and reflect that 2018 was a bit like 1948 than 1938. In 1948, excess savings began to be released and deployed for one of the largest ever economic advancements over the following two decades. 1938 on the other hand marked the political taking over of the populists in many countries that led to events we really do not want to see repeated.

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