Is there a lesson to be drawn from history? No two crises are the same but useful insights can be gleaned from comparisons, as Jerome Nunan explains.
Following a decade-long bull market, punctuated by occasional bouts of volatility, many investors have little or no experience of market conditions such as those we have experienced since late February. Understandably, many investors are asking whether this is a repeat of the Global Financial Crisis. With this in mind, we have compiled the following brief guide.
Global Financial Crisis (GFC)
- The GFC was a financial crisis that infected the real economy.
- The origins of the GFC lay in a vast misallocation of credit and excessive financial engineering.
- Essentially money had been lent to uncreditworthy borrowers. The subsequent repackaging of this debt meant that when it became apparent that the debt was non-performing, financial institutions did not know who held the exposures. This led to a systemic crisis, in which institutions became unwilling to lend to anyone.
- Paralysis within credit markets flowed into the real economy as companies collapsed and unemployment surged.
- This is a crisis in the real economy, that is being reflected in financial markets.
- COVID-19 and the measures required to contain it have caused vast swathes of the global economy to close.
- Markets started 2020 with stretched valuations in anticipation of a rebound in manufacturing and global trade.
- The impact of the pandemic has undermined these expectations and markets have now moved to price in a high probability of recession across most major economies, but uncertainty over the depth and duration.
The extent of the economic collapse during the GFC is laid out in Figure 1. The contraction in activity was significant, dwarfing declines that had been experienced in prior recent slowdowns such as the Dotcom bust of 2000-2003 and the Asian Financial Crisis of 1997-98.
COVID-19 is expected to have an even bigger impact on economies
However, as Figure 1 shows, the impact of COVID-19 is expected to have an even bigger impact on economies and be the biggest downturn since the 1930s.
Figure 1: Peak to trough GDP declines in crises
- A slowdown of the magnitude seen during the GFC will be accompanied by a sell-off in markets.
- People associate the GFC with the volatility of 2008, peaking with the collapse of Lehman Brothers in September 2008.
- In fact, markets peaked in October 2007 and early signs of stress were already appearing. In the US, this took the form of Bear Stearns’ early-phase collapse; in the UK, the run on Northern Rock.
So, by the time the heavy selling of late 2008 occurred, markets had been trending down for almost a year.
- Markets peaked in late February and risk assets have suffered heavy losses.
- Equities experienced peak to trough falls of about 35 per cent within the space of a month.
- While investors were aware of COVID-19 in January, it was viewed primarily as an issue for emerging markets (notably China), and companies with supply chains in the region.
- The scale of the response by Western governments and the speed of market repricing caught many off guard.
Figure 2 contrasts the moves in markets after hitting their respective peaks in October 2007 and February 2020.
Figure 2: Momentum of sell-off following market peak
It illustrates the speed with which the market drawdown has occurred in 2020, compared to the slow-burn during the first year of the GFC.
The true impact of COVID-19 was swifter and deeper
Furthermore, as Figure 3 shows, the collapse in markets as the true impact of COVID-19 emerged was swifter and deeper than that even in the weeks after the Lehman Brothers bankruptcy.
Figure 3: Market response to Covid-19 (Q1 2020) vs Lehman’s collapse (Q3 2008)
- In the US, which was at the heart of the difficulties, the response came in various ways.
- Most conventionally, the FOMC reduced its benchmark rate in a series of cuts from September 2007. Starting at 4.75 per cent, it took the rate to zero, with major reductions following the collapse of Lehman Brothers.
- More radically, the US government signed the Troubled Assets Relief Programme in October 2008 – committing $700bn to recapitalise financial institutions and support the auto sector. And, in November 2008, the Federal Reserve announced Quantitative Easing 1 (QE1), which entailed up to $600bn of asset purchases to put a floor under markets.
- In the UK, the Bank of England started cutting from 5.75 per cent in December 2007, eventually reaching 0.50 per cent in March 2009. And a QE programme of £75bn was also introduced in March 2009.
While radical measures were implemented, they were not universally favoured, and it took time to get agreement on them.
- The experience of 2008 has left policymakers better equipped to deal with COVID-19. The previous use of unconventional monetary tools, such as quantitative easing, means there is a proven means of deploying them when required.
- The fiscal response to COVID-19 has been unprecedented. Governments are committing to paying private sector wages, deferring tax obligations and increasing social security spending. In the US, this has been estimated at about 11 per cent of GDP, while in the UK it is about five per cent.
- Central banks are moving at speed to support this fiscal spend by buying the debt governments need to issue. For example, the Federal Reserve has committed to “using its full range of tools” and announced purchases of at least $500bn of Treasuries, $200bn of mortgage-backed securities, providing $300bn in financing to employers, consumers and businesses through various programmes.
- Meanwhile, in the UK, the Bank of England has announced £200bn of QE to support the government.
What can we learn?
Both crises can be characterised by fear of the unknown. Today, fear is driven by the extent to which COVID-19 has infected the broader population; how long it will be before people can resume normal life; and what normality in future might look like. And while the financial crisis may have felt like a transitory event from a market perspective, at the time it felt just as existential as the current pandemic. Given the uncertainty about what the global economy might look like over the short to medium term, it is understandable that investors have reacted in the way that they have.
Markets will reprice future growth long before the economic data supports such moves
Greater clarity in relation to the spread of the virus and our ability to counter it will help determine whether current valuations are fair or a good buying opportunity. But markets are a forward-looking mechanism and, while we shouldn’t discount the possibility of further volatility ahead, we should remember that markets will reprice future growth long before the economic data supports such moves.
Authorities have moved at speed to deal with the immediate economic consequences of the pandemic. Investors should maintain a clear line of sight on their long-term goals and the opportunities currently on offer.