Ten years on: The ghost of Lehman
4 minute read
We explore the lessons from the global financial crisis and what lies ahead for bond markets.
If you lined up all the column inches that have been splurged on the financial crisis since Lehman Brothers went bankrupt you would have enough material to cover the globe many times over. Yet on the flip side, if you undertook a similar task with the people who actually predicted it, you would be lucky to make it around the block. Although somewhat of an exaggeration (in the case of the latter), the point is merely how easy it is to be wise after the fact.
Lehman marks a defining moment in financial and political history. Its lessons – the majority of which have been debated to death – will inevitably be forgotten as the next wave of hubris takes hold. Nevertheless, it is important to at least try to stave off the next wave of financial amnesia from which the industry repeatedly suffers.
So, what have we learnt?
Firstly, do not bet against central banks. Their unprecedented intervention – three-and-a-half rounds of quantitative easing and nearly US$4 trillion of asset purchases undertaken by the Federal Reserve, as well as Mario Draghi’s proclamation that the European Central Bank would do “whatever it takes” – has provided a constant reminder of central bank influence and firepower.
Second is the human instinct to focus on triggers rather than underlying causes. From the banking sector to trade, large imbalances and risks have been building and threaten to bubble up. Nowhere is this more obvious than between the US and China; amid all the twitter-fuelled geopolitical posturing the critical details can be easily lost – for instance, if the US and China apply equally-weighted tariffs, China will end up far worse off due to its heavy reliance on exports.
Our final key lesson is the importance of security selection. Somewhat of a lost art as markets have been driven by excessive liquidity, propping up assets indiscriminately, critical analysis and understanding of fundamental drivers in credit markets will come to the fore. For example, as interest rates rise dispersion is likely to increase within sectors, favouring companies with stronger balance sheets.
As portfolio managers, we have also had to contend with the very nature of risk being called into question as the occurrence of once-in-a-generation events started to happen uncomfortably frequently. Our cynical disposition as fixed income investors means we tend to take a negative view of everything and this piece looks at the pitfalls in market pricing and as well challenging some of the received wisdom swirling around markets.
Crisis, what crisis?
One of the current ironies in markets is, depending on the metric you choose, that you could be forgiven for thinking the global financial crisis was an irrelevant dot on the horizon. Global growth is relatively strong, equity and property markets are at, or close to, all-time highs across a number of core markets. Indeed, the S&P 500 has marked several new all-time highs this year; as did the Indian Sensex index. Property markets, particularly prime space, commercial and residential, in major cities across the globe have boomed.
Debt – will we ever learn?
A recent McKinsey report on the crisis opens with the line: “It all started with debt.” Few experts would disagree and armed with this knowledge it is astounding to consider the problem has barely been addressed. Fixing the roof while the sun is shining is often touted as a golden economic discipline. In other words, debt levels should have been radically reduced during this period of economic expansion. However, in the ten years or so since Lehman, the reverse is true. In its latest Fiscal Monitor publication (April 2018), the IMF warned that the global debt pile had risen to US$164trn, or 225 per cent of global GDP, exceeding the 2009 level of 213 per cent of GDP. Even as austerity has been implemented in countries such as Greece and the UK, overall debt levels have grown faster than GDP.
Take Europe. Figure 1 clearly highlights the endemic problem. A similar picture emerges at the corporate and household level.
Figure 1: European debt to GDP in selected nations
Gauging the next recession
The current economic cycle is in its later stages, with some warning that we are overdue a recession. This is borne out by flattening yield curves – in the summer, the spread between two-year and ten-year Treasuries narrowed to levels last seen in 2007: right before the financial crisis. Indeed, in the period since the Second World War, a typical economic expansion has lasted for about six years. That said, our base-case scenario discounts the idea of recession in the next 12–18 months. The flattening yield curve is perhaps symptomatic of demand pressure at the long end, thanks to the long-enduring ‘quest for yield’ we’ve seen in recent years.
The US is another important consideration. In contrast with 2017’s trend of ‘synchronised’ global growth, this year the US is proving to be the driving force behind the global economy. Trade spats aside, the tax cuts enacted by the Trump administration have prolonged the current expansion – and the effects of this are likely to continue. An imminent global recession should therefore not be high on the list of risks facing investors.
Rates – a new, lower ‘normal’
With this in mind, the timing and nature of ‘normalised’ monetary policy has preoccupied fixed income investors for several years. It is time to face what will be a ‘new normal’; one less reliant on central-bank support.
Figure 2: The path of interest rates: The 'new' normal will be much lower in future
Our view is that, when considered in a longer-term context, the range of rates set by global central banks is likely to be lower. Back in the 1980s for example, the UK policy rate briefly stood at 15 per cent, and was consistently over 10 per cent. In successive market cycles, the policy rate has become lower as the economy becomes more mature. Higher rates mean larger interest payments for governments. And for that reason, policymakers might find it more prudent to keep rates in a more manageable range. Global central banks are acutely aware of the enormous outstanding debt pile that has been built up and the cost of servicing that debt pile. The future imperative would seem to be a tricky balancing act of keeping inflation under control and rate rises to a minimum.
Beware of duration
As issuers of debt have sought to take advantage of near-insatiable demand for income, the term lengths of bond maturities have risen considerably which has serious implications for investors ‘hugging’ a benchmark. As benchmark yields fall, benchmark duration rises as a greater proportion of return relative to the underlying par value increase. Put simply, your spread cushion is lost and your portfolio becomes more sensitive to interest rates, at a time when they are only heading in one direction: up. As Chris Higham, senior portfolio manager at Aviva Investors says: “If you don’t actively consider duration, you’re almost sleepwalking into a capital loss”.
Global high yield – finding value
Given this backdrop, the most successful approach is likely to be one that is actively managed and fully attuned to the nuances of the market. One area in which we have increased allocations is European high yield.
Firstly, this is because there is less of a fundamental credit concern in Europe. As we hedge the currency risks, carry can be made, making a compelling valuation argument. For example, yields on European ‘BB’ bonds offer around 120 basis points (bps) more than US equivalents, while single ‘B’ names offer an additional 200 bps (as at 21.09.2018). But, crucially, the forecast for defaults is lower. Yield spreads have been driven wider by higher political risk, stemming from Italy, causing European credit to be an underperformer in the year to date. These factors together lead to buying opportunities.
Furthermore, “spreads typically lead defaults by 9–12 months, and right now spreads are historically low”, suggests Sunita Kara, senior portfolio manager at Aviva Investors. Consequently, we are not unduly concerned about defaults – particularly as high yield is supported by a sound fundamental and macroeconomic backdrop.
Potential banana skins
One area we’re monitoring particularly closely is the investment-grade market. About half of the investment-grade market is comprised of ‘BBB’ bonds, issuance of which has proliferated in recent years. “When the next recession comes around, 10–20 per cent of ‘BBB’ bonds are likely to fall into the high yield space”, highlights Kara. That could be problematic if there’s insufficient demand for high-yield bonds, and would likely cause read-across into valuations.
There would also be implications for some investors in owning securities that no longer form part of the benchmark index. From our perspective, as active investors we are able to hold bonds that are ‘off-benchmark’, therefore giving us control over when to sell. For example, if a bond we hold is upgraded from high yield to investment grade – a ‘rising star’ – we can hold on to the security and benefit from the subsequent spread tightening (typically on a six month lag).
Taking a cautious approach
Inflation is rising but only gradually which affords central banks time. Most of the pressures have been from the more volatile elements of fuel and food. Core inflation rates, which exclude these volatile items, has been far flatter. Similarly, while occasionally threatening to burst upwards in economies where the labour market is tight – such as the US – wage inflation has been largely kept under control. Indeed, in some economies the fight against deflation is still alive, not least Japan and peripheral Europe.
However, as inflation expectations have started to creep up, Treasury-Inflated Protected Securities (TIPS) have merited attention. We held this view earlier in the year as we felt investors were not accurately pricing in US rate hikes.
There has also been an uptick in volatility this year, on the back of political risk, trade skirmishes and the potentially overheated US economy. That’s informed a cautious view. In our flexible mandates and funds, we have reduced overall credit risk (on the basis that spreads are tight), and prefer shorter-dated names – in both high yield and investment grade. This is predicated on the assumption that as central bank liquidity gets withdrawn it is likely we will see greater dispersion of returns across bond markets, and individual names. In short-dated investment-grade credit, we have initiated positions in where we are confident in the company and the credit risk – plus they offer a low duration and respectable yield. Examples include telecommunications companies Telefonica and KPN.
In terms of Brexit, “The risk is not adequately priced into sterling credit valuations”, according to James Vokins, senior portfolio manager, and therefore our UK exposure is tilted toward the more internationally-focused issuers. In this context, sterling risk doesn’t mean Brexit risk.
The next crisis, when it inevitably comes, will teach us new lessons. However, only by having the humility to learn from the past can we have any hope of making it through the next one. Being wary of the distorting effects of central bank, attuned to global and local imbalances, and prepared to do rigorous due diligence will stand investors in good stead. In that context, the amount of ink spilt on the global financial crisis is hardly surprising. Let’s just hope we can make it slightly further around the block next time.
The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.
Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.
These strategies use derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the strategies may suffer significant losses.
These strategies may invest in other strategies, which means the overall strategy charges may be higher.
Certain assets held in these strategies could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.
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