Among all the different questions investors have had to confront in the past five days, only one really matters: have we just witnessed a “Lehman moment”? At the risk of sounding like a Jesuit priest, I will answer this vital question with a bunch more questions. The first is: have the financial market’s core beliefs now been shattered?
Before Lehman, almost everyone in the financial markets bought into the belief that cutting up risk into small pieces and reaggregating the risk into structured products was a wise idea which reduced the overall risk for the financial system, and thus allowed for more leverage. A further belief back then was that investment banks, hedge funds and other financial intermediaries were run by really smart guys who managed their risk carefully. But when Bear Stearns and Lehman Brothers failed, this belief was shattered and the mass of excess leverage in the system (which rested on the belief that risk syndication made sense) had to be unwound precipitously in a market with no market-maker. The world found out that most financial market intermediaries had not made fortunes by being exceptionally smart; instead, they had made fortunes by being excessively leveraged… fortunes that were then abruptly taken away.
So, as a result of last Thursday’s vote, have any core beliefs amongst market participants been broken? That seems unlikely. Did anyone really believe, massively leverage up, and invest on the premise that the “one size fits all” policies dished out by the Brussels boffins were a great and sustainable idea? Frankly, the writing on the wall has been as visible as a Banksy tag for a while. Instead, the question for most investors has not been “whether” we would see Brexit (or Spainoyara, or Italeave, or Departugal, leaving us in the end with Germalonely) but “when” one of these events would happen.
Interestingly, by the day of the vote, the markets seemed to have convinced themselves that Brexit would not happen and that the EU show would stay on the road just a little while longer. When that turned out to be untrue, markets promptly took out the “no Brexit/post-Jo Cox murder” rally of the preceding days. In a matter of seven hours, the pound went from its highs for the year, to a 30 year low!
But this sudden move raises the possibility that another of the market’s “core beliefs” was shattered on Friday, namely the belief that policymakers will always be there to dish out cash and prop up asset prices. After all, to some extent, the Brexit vote could be interpreted as the rebellion of the “don’t have so many assets” against the “own lots of expensive assets” classes (look how, for example, Sheffield, Wales, and Sunderland voted against how London voted). What is amazing is both how peaceful this rebellion has been, and how long it took. At the risk of sounding downright Marxist, the Western world’s leadership decided that the right response to the shattering of the “2008 core belief” was to further prop up asset prices with lots of borrowed cash, thereby making the owners of overpriced assets even richer, and dramatically exacerbating the wealth differences within their countries (what else do zero interest rate policies and quantitative easing do but ensure that young people are unable to afford real estate?).
Now importantly, the idea that prevailed over recent years, that policymakers knew best and could always prop up asset prices, has been a “core belief” that rubbed a large number of investors up the wrong way, so few would have leveraged up massively on the premise that the “new paradigm” that was unfolding was sustainable. This is a very important difference between today and 2008. Simply put, the leverage in the system is not as great in the private sector (except perhaps on US corporates’ balance sheets, as CFOs have spent the past few years buying back stock) as in the public sector. It is unlikely that a majority of investors would have bought in to this “new paradigm”. Take our own microscopic shop as an example: the belief that the technocratic classes knew best and would underwrite growth and asset prices from here on out (a core tenet of