With the 10th anniversary of the collapse of Lehman Brothers upon us, it is instructive to look back over the period and ask ourselves what, if anything, we have learned from living through these exceptional events. As is often the case, actual new lessons to be learned may be few, but there are some valuable older lessons to be relearned.
To help the analysis, we’ve divided the period into three: the crisis itself, the immediate reaction to the crisis and the long post-crisis period — the aftermath. We’ve also provided our thoughts from a New Zealand perspective, to really highlight what this means for local investors.
Lesson 1: Credit cycles are inevitable.
The 2008/2009 global financial crisis was an extreme boom-and-bust variant of that cycle.
Growth driven solely by leverage is both increasingly risky and likely to sow the seeds of its own destruction.
Lesson 2: The financial system is based on confidence, not numbers.
Lesson 3: Managing and controlling risk is a nearly impossible task.
Financial models have their uses, but they are only one tool in the tool box and need to be supported by other risk-assessment methods. To be fair, market participants have recognized this issue and have sought to develop more-robust risk models in addition to reducing their reliance upon them.
Lesson 4: Don’t panic!
Lesson 5: Some banks are too big to be allowed to fail.
The lesson learned is that risk/reward alignment remains asymmetric within the financial system
This misalignment seems certain to generate future crises, albeit, no doubt, in a somewhat different form.
The global financial crisis (GFC) of 2008/2009 was not a crisis just like any other, but there were perhaps fewer new lessons to be learned from that period than one might have expected. There was a degree of relearning lessons, albeit in slightly different form, from previous financial crises and the period since the spring of 2009 has definitely taught us new things about how both the global economy and the global financial system work. It is within this period that the most interesting lessons have been learned.
Lesson 6: Emergency and extraordinary policies work!
These were previously untried and untested policies, so no one knew whether or how they would work in practice. The answer to the “whether” question was “yes”, they would and did work. But the “how” remains uncertain. We still don’t know what the full-cycle effects of QE will turn out to have been, as we have yet to go through the phase of its complete withdrawal.
Lesson 7: If massive amounts of liquidity are pumped into the financial system, asset prices will surely rise
The impact of QE on the “real economy,” (levels of growth, unemployment, etc.) was much more muted at the outset, although it is difficult to judge the extent to which economic activity would have fallen without QE.
Lesson 8: If short-term rates are kept at extraordinarily low levels for a long period of time, yields on other assets will eventually fall in sympathy
The yields on nominal sovereign bonds are probably floored around zero, although real yields have no discernible floor. Fixed-interest bond yields did fall slightly below zero in a few countries in mid-2016, but governments seem to have recognized that such low yields were not effective as a policy tool to stimulate economic activity.
Lesson 9: Extraordinary and untried policies have unexpected outcomes.
Against almost all expectations, these extraordinary monetary policies have to date not proved to be inflationary, or at least not inflationary in terms of consumer prices. But they have been inflationary in terms of asset prices.
Lesson 10: The behavior of securities markets does not conform to expectations.
Excess liquidity and persistent low rates have boosted market levels but have also generally suppressed market volatility in a way that was not widely expected.
A combination of low volatility and markets heavily influenced by both macroeconomic policy and geopolitical forces has created a difficult climate for active managers, who have struggled to consistently generate added value.
It has also undermined the case for prudent diversification of risk and return sources — a simple 60% equity/40% bond portfolio would have been a great strategy pretty much throughout the post-2009 bull market.
THOUGHTS FROM A PEEK INTO THE FUTURE
Are we entering a period similar to the pre-crash period of 2007/2008? There are undoubtedly some likenesses.
But there are differences as well.
Thought 1: The next crisis will undoubtedly be different from the last – they always are.
Thought 2: Don’t depend on regulators preventing future crises.
Thought 3: The outlook for monetary policy is unknown.
Put another way, the last few years may prove to be a foretelling of the next period (historically low rates and bond yields for the foreseeable future) — what commentators have suggested is the “new normal.” Or, with the benefit of hindsight, this period may prove in the long-distant future to be an isolated and individual one of low rates and yields, rising markets and suppressed volatility. We do not and cannot yet know the answer to this conundrum.
SO WHAT NOW?
Even without knowing, there may be some sensible actions that can be taken, based on sound, long-term principles rather than the still-not-fully-understood experience of the post-GFC period.
These principles are consistent with Mercer’s investment beliefs and are fundamental to how we manage the Mercer funds.
Action 1: Don’t abandon diversification. Diversification has been called “the only free lunch in investment”. By combining different asset classes, total return is the average of the underlying asset class returns, but total risk is less than the average risk due to the lack of correlation between the different asset classes. Over long, multicycle periods, a diversified portfolio will achieve superior risk-adjusted returns, provided it is robustly constructed and there is genuine diversification of risk and return sources.
Action 2: Be dynamic! The fact that asset markets are at close-to-record highs doesn’t mean all assets are equally expensive. Some assets, particularly certain equities, have been driven to record highs by underlying growth in profits, not by ever-increasing valuations. Other assets have been driven by liquidity and technical factors rather than improving fundamentals — long-duration bonds, for example. Although these factors may continue to support high valuations in the near term, they may eventually become unfavorable.
Action 3: Don’t abandon active management. Suppressed volatility and a rising tide of liquidity lifting all boats have created a tough environment for many active managers. But conditions will change. Liquidity will become less supportive, and markets will become more discriminating. Remember that index-tracking management’s biggest flaw is that it never buys cheap and sells dear, it just goes on holding all the way up and all the way down again!
Philip Houghton-Brown is the Chief Investment Officer at Mercer Investments New Zealand. He helps ensure sustainable growth for our clients and customers across their investment portfolio.
© 2018 Mercer. This document has been prepared by Mercer (N.Z.) Limited.
It is intended for general guidance only and is not personalised to you. It does not take into account your particular financial situation or goals. It is not financial advice or a recommendation.