Are investors sleepwalking into another major financial crisis?
‘Only when the tide goes out do you discover who has been swimming naked’... so said Warren Buffett, who is avoiding buying equities as US stocks hit record highs
These may be the dog days of August when traders and investors head to the beach, but this week marks a seminal moment in the history of global finance.
It was ten years ago on Wednesday that BNP Paribas, a French bank, prevented investors from accessing funds exposed to US subprime mortgages, citing “a complete evaporation of liquidity.” For many, this was one of the triggers for the credit crunch which led to the most severe financial crisis in history.
Much has transpired since the outbreak of the Great Recession.
Financial institutions have been fined more than US$150bn in the US, mostly in order to settle allegations that they misled buyers of securities backed by mortgages.
Markets have been flooded with liquidity as leading central banks embarked on aggressive programmes of quantitative easing aimed at kick-starting crisis-stricken economies. Perhaps most importantly, a fierce backlash against globalisation and political elites led to last year’s decision by Britain to vote to leave the European Union, followed by Donald Trump’s upset victory in the US presidential election.
Yet one of the most troubling after-effects of the credit crunch is the glaring disconnect between crisis-scarred economies and buoyant markets - the very same decoupling that laid the foundations for the credit crunch.
Advanced economies are still struggling to recover from the Great Recession. While the US returned to its pre-crisis level as early as 2010, the UK took another four years to surpass the peak it hit in the opening quarter of 2008. In the eurozone, economic output only exceeded its pre-crisis level in the first quarter of last year, six years after the bailout of Greece’s economy triggered Europe’s sovereign debt crisis.
Italy, Europe’s third-largest economy and the country most likely to trigger the next crisis in the eurozone, is not even close to surpassing its pre-crisis high. According to the International Monetary Fund Italy is poorer, as measured by real disposable income per head, than when it joined the euro in 1999.
Just as worryingly, public indebtedness across the eurozone has increased significantly, partly due to the costs of government and bank bailouts. Public debt as a share of GDP in the bloc has shot up from 65 per cent just before the crisis to nearly 90 per cent last year, according to Europe’s statistics bureau. One third of the members of the eurozone now have public debt levels close to, or above, 100 per cent of GDP, including Spain, the supposed poster child of the eurozone’s recovery.
Yet in the world of finance, the grim legacy of the Great Recession receives scant attention, increasing the risk that investors will sleepwalk into the next crisis.
While vulnerabilities in the financial system have been addressed – albeit in a much more rigorous and timely manner in the US than in Europe – and credit growth is nowhere near the bubble-like levels witnessed in the run-up to the 2008 crisis, the current excesses and complacency in markets are eerily reminiscent of the danger signals leading up to the credit crunch.
As global stocks have surged to record highs, spreads (or the risk premium) on many corporate bonds have reached their tightest levels since the credit crunch and the Vix index - Wall Street’s so-called “fear gauge” - has tumbled to a historical low, markets have become dangerously somnolent, seemingly impervious to a plethora of financial, economic and (geo-) political risks.
A surge in demand for so-called “haven” assets on Wednesday following a severe escalation in tensions between North Korea and the US still left the Vix standing at just over 11 points, a whisker above its record low.
While there are grounds for optimism in markets - a pick-up in global growth, especially in Europe, and robust corporate earnings - ultra-loose monetary policies have distorted asset prices to such an extent that they no longer reflect the risks that lie ahead.
When even Italy’s 2-year bond yield is in negative territory and spreads on some US “junk” bonds are close to their all-time lows, it should be patently clear that risks are being woefully underpriced.
While the probability of another financial crisis as severe and as far-reaching as the one that began a decade ago is extremely low, investors are poorly positioned and ill-prepared for the end of quantitative easing, increasing the scope for a sharp correction - and one that could be amplified by tensions on the Korean peninsula.
It was Warren Buffet who famously quipped that “only when the tide goes out do you discover who has been swimming naked.” Investors lying on the beach this August would do well to ponder Buffet’s warning.