Over the next few weeks, I will be writing a series of pieces on trends in the global economic landscape, and what the implications of these trends are for investors. In this edition, we take a look at what might be the biggest bubble in recent memory: The financial crisis of 2008.
What goes up must come down
– Sir Isaac Newton (1642-1727)
Because the global financial system is heavily levered and dependent on debt, a prolonged downturn in growth can have devastating consequences for the economy. Policymakers are cognisant of this, which is why they attempt to buoy the real economy via expansionary monetary policy (i.e. more debt). The result of this is that the economy begins each cycle from a higher level of leverage and the lack of purging of prior excesses leads to even greater vulnerability and thus a greater necessity to continuously limit the downside of the economy. This phenomenon is commonly referred to as the debt “supercycle”.
At the turn of the century, the bursting of the tech stock bubble amid a fragile global economy was of great concern to policymakers. As a result, interest rates were relaxed significantly all over the world, creating a housing bubble in the process. Similarly, over the past two years, global central banks and governments have slashed rates to near zero and have implemented, to varying degrees, quantitative easing programs and stimulus packages designed to spur economic activity.
In many respects, the financial crisis of 2008 resembles what happened in the savings and loan crisis of the late 1980s, where a collapse in the commercial real estate completely shut down the securitized debt market and junk bond market. Like in the 1980’s, aggressive policy easing provided an incentive for financial institutions to lend to higher risk borrowers. Heading into 2004 and 2005, financial innovation turned into mutation as CDOs and other new structured financial products were purchased by a large pool of investors seeking yields exceeding those on government debt, given that yields on government securities were at secular lows
The credit bubble followed the historical script almost to the letter, with spreads on virtually all non-government securities being driven to record lows and deep into overvalued territory. Investors were sobered in February 2007 when house prices moved against the consensus that they would rise “forever”. Naturally, this posed a significant threat to the balance sheet health of financial institutions, and to this day we have yet to see any concrete evidence that bank write-downs will stop. Stocks tumbled, bond spreads spiked, and yields on short-term government securities were pushed downward as investors dashed for cash.
However, the consensus remained that the problems in the U.S. housing market were isolated and would not have knock-on effects to the rest of the economy. Credit problems returned with a vengeance, sending stocks into a bear market. The Federal Reserve capitulated and has pulled out all the stops to reflate the U.S. economy and bail out the ailing financial system. In addition, the world’s other major central banks have joined the party in attempting to restore order in the credit markets, with the ECB, Bank of England, Bank of Canada, among others, having injected over USD 1.5 trillion into the system. While the coordinated action of central banks and government appears to have limited the damage caused by the financial crisis, the underlying problem of too much debt in the system remains. The only difference is that now, government is doing the borrowing in lieu of the private sector.
Fast forward to today. The stock market appears to have bought into the idea that a recovery is here. After all, earnings are beating expectations and recent economic releases have been encouraging (or not as discouraging with respect to employment). So what’s next? We’ll look at the investing implications of the methods employed to alleviate the crisis in our next piece. Stay tuned!
Disclosure: No positions at the time of writing.
Disclosure: No positions