Déjà Vu...All Over Again?
For many, the rapid fall in confidence in the global economy and sharp decline in equity indices reflect concern that the near-term impacts of slowing growth, overall debt burden, government and municipal fiscal deficits, new austerity, and the risk of policy mistakes will drive us into a “double-dip” recession.
Is It 2008 Again?
In evaluating near-term prospects for economies and markets, it is instructive to compare the current situation to the global financial crisis in 2008. The reemergence of credit market stresses, the sharp increase in volatility, and the incoherent efforts of policymakers to intervene, all reinforce that sense of déjà-vu. According to this view, the troubles in Europe’s periphery are simply the tip of the iceberg, much as the collapse of subprime mortgage market was just part of a much larger housing and financial problem. Moreover, many now assume that the recent strains seen in credit markets are an early warning signal of a broader global banking and economic growth problem, as they turned out to be in 2007 and 2008.
With those wounds still fresh, it is unsurprising that many people are predicting the European sovereign crisis as the first steps along a similar path. It is striking how quickly and extensively this downside scenario has been reflected in capital markets relative to the 2008 episode. In 2008, the economy was already experiencing a liquidity crunch and actual defaults before we saw this kind of capital market response. This time, there seems to be little patience. Once burned, twice cautious.
Of course, the current sovereign problems and the earlier global financial crisis are not really distinct events, but rather are intimately linked. The policy response to the economic downturn and banking-sector issues was to transfer those problems from individuals and corporations onto the public sector through guarantees and deficit spending. The hope was that, once there, those problems could be addressed over a much longer period of time. Markets are challenging that assumption in Greece and beyond. In that respect, the sovereign crisis is the aftershock of the broader financial crisis.
History has a tendency to look inevitable through the rear-view mirror. The global financial crisis of 2008 is sometimes discussed as if the subprime meltdown was the root cause of the broader problems. But the crisis was in fact the result of a long period of easy credit and housing imbalances that had already begun to unwind in 2005 and 2006. The real question is therefore whether the government imbalances that we see currently are as dangerous and as vulnerable to a rapid unwinding, and whether a comparable transmission through the banking sector is possible.
Some Advantages Over the Mortgage Meltdown...
There are several reasons why the current sovereign crisis may be more manageable than the mortgage meltdown:
- Governments have more options than households, corporations, and banks. By virtue of their power to tax and spend, governments have more control over their ability to repay debt than private entities. For that reason, in the end, the ability to avoid default is most often about political will and institutional strength to manage public response.
- The most likely problem sectors are smaller and not dominated by highly-levered institutions. In the global financial crisis, the damage was amplified by the fact that the impaired pool of US mortgage assets was large, widely dispersed geographically (transmitting losses to European banks) and skewed towards highly levered institutions. The European bond market is smaller than the US mortgage market and the banking sector’s share is lower, so it would take a huge default rate (far more than a single peripheral European country) to match the hit from US mortgages.
- Bank liquidity positions are generally better and backstops more widespread. For US banks, capital ratios have improved markedly since 2008. The capital position of the European banks may be less robust, but still improved. In addition, liquidity backstops put in place by central banks in 2008 are much larger than what existed as the crisis erupted in 2007 and 2008.
- Private-sector imbalances are much smaller. Although the public-sector fiscal position has deteriorated, this has been accompanied by a sharp improvement in private-sector financial positions. Private-sector financial balances have moved into substantial surplus in the major economies and the US household sector has become a net lender for the first time in the post-war period.
- Markets have not seen the interest rate and commodity shocks of 2007-2008. The run-up to the global financial crisis saw economies in a very different cyclical position. In 2007/2008, inflation was picking up across a broad range of economies, oil prices were rising sharply, and interest rates were high in many parts of the world. The policy and commodity ‘shocks’ that contributed to the cyclical slowing in mid-2008 are largely absent now.
...And Some New Risks
The comparisons to that recent past are not all favorable, however. As is often the case with economics (where are the one-armed economists when you need them?!), some of the biggest concerns in the current situation are simply the flipside of the positive aspects above:
- Governments are the ultimate guarantor. Although government defaults are much less likely than corporate and banking problems given the greater tools at their disposal, the consequences may be more severe. In particular, the global financial crisis and the banking system freeze were mitigated to a large extent by government guarantees. If government backstops come into question, private sector risks reignite.
- Policy options limited if more stimulus is needed. Interest rates are much lower than they were in 2008/2009, so options for fresh stimulus if the cycle slows again are severely constrained.
- A prolonged era of weak recovery may be problematic. In significant parts of the world, a self-sustaining private demand recovery is not yet evident and inflation is very low. A longer patch of sluggish growth would increase the risk of outright deflation.
- Europe’s institutional problems demand a high level of policy coordination. The unique challenges of fiscal problems within the Euro-zone and the EMU raise questions about mutual support and require a high level of inter-governmental coordination to address.
- Sovereign worries would be less manageable if they do spread. If pressure on governments themselves spread to include some of the larger economies, the pool of potential problem assets would clearly be much larger.
How do these advantages and risks balance out? The more positive features suggest that we are much less likely to run into a serious global default and banking system problem than in 2008. The more negative features suggest that if, however, a widespread sovereign problem occurred, the consequences would likely be worse.
Our basic conclusion is that the probability of a dangerous transmission of European sovereign worries through the global banking system is significantly lower than it was in 2007 and 2008, despite some of the similarities in the initial market response.
The 2008 analogue presents two useful lessons. First, policymakers rarely have a “silver bullet” for the resolution of these kinds of balance sheet concerns. While governments around the world employed massive (and controversial) policy actions in 2008 and 2009, there was no single defining moment and it became clear only slowly that the set of responses was proving effective (some still argue the point). Second, it is hard for markets to go higher in the context of increasing credit concerns and a slowing of economic growth. Until global economic growth news begins to surprise positively again and the weight of government credit concerns recedes, investment markets face continued headwinds.
As comprehensive managers of our clients’ wealth, we must find a way to respond intelligently to a very negative scenario that is possible but, we think, improbable. The sharp rise in equity volatility and the pressure on equity indices and other “risk” assets, suggest the market is in real doubt about the outcome. The speed at which it has done so in some areas is significant – equity market volatility and credit concerns about European banks and some countries have moved to levels not seen since the immediate post-Lehman period.
Still, we believe the market is underestimating the impact of lower interest rates outside the affected economies (e.g., mortgage rates in the US) and the stabilizing power of the emerging economies. If we are correct, a number of asset classes now look very attractively priced and may rise quickly at the first sigh of relief.
As you know from long experience with us, our threshold investment concern is to “do no harm.” Our clients’ financial goals will be accomplished primarily through profitable long-term participation in the growth of the global economy; it would be a tragedy if we fostered the mistake (all-too-common for laymen) of selling low and buying high, particularly in the context of tactical asset allocation and an attempt at market timing. So, until our expectation of long-term returns and relationships changes, our response to these current events would be limited to opportunistic strategies in asset class rebalancing and optimization of tax consequences.
Please also see our ongoing commentaries on markets and economies (most recent post, May, 2010) at Market Viewpoint.
While the current level of risk is probably higher than at any time since the market recovery began in March of 2009, our expectations for long-term return potentials remain intact.
Dr. Jason Thomas, PhD
Chief Investment Officer