Economies rebound to near post-crisis ‘perfection,’ but it’s too early to be confident
Last week saw the tenth anniversary of one of the pivotal events of the global financial crisis, when a prominent investment bank suspended redemptions on some of its investment funds. With US equity markets now trading at record highs, volatility extremely low, and economic growth around the world showing encouraging signs, the world has moved on a long way from when the US housing crisis caused liquidity to evaporate, exposing the dangerous interconnectedness of the global financial system. However, even as the world appears to have recovered from the crisis, we are still living with some of the remnants of it, which when allied to new risks could still cause problems to markets that are now “priced for perfection”.
This is not to say that we are heading to a repeat of the 2007-08 crisis, but that investors need to be alert to the risks that sentiment may have swung too far the other way.
The starting point of the financial crisis revolved around the US housing sector, and principally the over exposure of banks and financial institutions to the sub-prime segment. Fortunately this is no longer likely to be source of any future disruption as the valuation of housing is not as stretched as it was then, affordability is much better, banks are better regulated and capitalised, and housing inventory is low. However, the seeds of future crises are never likely to be exact replicas of past ones. Debt bubbles may have dissipated in housing, but are beginning to show up in other areas such as student loans and subprime auto loans which need to be watched.
Credit bubbles overseas, particularly in China may also be a source of future problems, with the corporate sector there heavily leveraged and vulnerable to a sharp slowing in growth. Fortunately the Chinese authorities are handling the rebalancing of the economy fairly well, such that a sudden collapse in growth looks unlikely. Also, with most of China’s debt held internally, the systemic risk to the global economy from deleveraging looks likely to be limited.
Elsewhere the global economy looks to be in the best shape it has been in for some time, also providing reassurance that past imbalances are being repaired. Recent data from around the world appears to be consistent with steady, if unspectacular growth. Where there are problems, in terms of low productivity growth and investment, these are unlikely to be the spur for any short term crisis but will probably reveal themselves in lower potential future growth rates. So encouraging has been the recent performance of the world’s largest economies that monetary policy normalisation is today on the agenda of most central banks.
It is here, however, that policymakers and investors need to tread carefully. While many of the “causes” of the global financial crisis appear to have faded, the scars and consequences of it remain, such that we are still observing anniversaries of the event. One of the most concerning features of the current recovery is the absence of inflation, which in part speaks of a low level of confidence. Even as unemployment falls in many developed economies to historic lows, wage pressures remain muted and pricing power limited.
Tightening monetary policy too aggressively in such an environment, either through raising interest rates or reducing central bank balance sheets, could set off another wave of anxiety, albeit of a different kind. Two prominent funds last week said that now is the time to dial back on risk, by reducing exposure to US equities and high yielding debt and by shifting to lower risk assets.
Markets currently give just a 40 per cet probability of a third US rate hike by the end of this year, with only one more rate hike actually priced before the end of 2018. This looks too low given the US economy’s expected performance. The negative reaction to the latest tensions between the US and North Korea also suggest a surprising level of “surprise” about that situation. Similar complacency probably exists over a number of other issues that lie ahead, including about the US debt limit, tax reforms, and the Russia probe. The financial crisis is unlikely to repeat itself but there are a number of new risks that make “pricing for perfection” a dangerous business.
Investors need to be alert to the risks that sentiment may have swung too far the other way