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Escaping Lehman’s shadow

Financial markets have staged a remarkable recovery since the fall of Lehman Brothers, but it’s been a joyless affair,” says Vice Chairman Edward Bonham Carter. “The ending of central bank support, both feared and wanted, hangs like a sword of Damocles over the market.”

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Ten years on from the collapse of Lehman Brothers, the unorthodox measures central banks took to dampen the fires of the global financial crisis have left a smouldering terrain that has cast a pall over the global economic recovery. Asset prices may have hit all-time highs but confidence remain fragile; fears the next global shock may be round the corner makes for skittish investors as we have seen with the currency crises in Turkey and Argentina. Unhappy anniversaries of the Lehman kind do little to soothe nerves, with the media likely to put as much focus on what remains to be fixed than on the very real progress made since those febrile days of 2007-08. Yet, it is only by understanding where the vulnerabilities lie in the current economic system that we can hope to shield ourselves from the next downturn. Lehman 10 years on provides us with just such an opportunity.

A marriage of convenience

For the last decade financial markets and central banks have been locked in a tight embrace. It’s an embrace that has increasingly felt like a straight jacket. When central banks slashed interest rates and introduced bond buying programmes (quantitative easing) to inject money into a financial system where liquidity had dried up, markets welcomed the move. It rebuilt trust among market participants and asset prices began to recover. For some though, what was supposed to be a temporary measure has gone on for far too long, and with nefarious consequences. The scale of central bank intervention has been so colossal that the four major central banks – the US Federal Reserve, the People’s Bank of China, the European Central Bank and the Bank of England – now hold some $20tn in assets on their balance sheets. Critics of the programme argue, perhaps with some justification, that it has led to overinflated asset prices. They also worry that central banks will further destabilise markets as they seek to shrink their balance sheets. All too quickly, the market recovery of the last 10 years can appear to be on shaky ground.

Breaking up is never easy

Yet, both the central banks and the financial markets know they have to escape this straight jacket they find themselves in. Central banks need to be able to raise interest rates and reduce their balance sheets otherwise they will have no firepower at their disposal to fight a future global shock. Imagine if interest rates had been where they are now at the start of the global financial crisis ten years ago. Financial markets understand this vulnerability but are struggling to wean themselves off an unprecedented period of low interest rates and have grown used to central banks being a backstop when times turn tough. Central banks in turn have been very cautious about raising rates for fear of extinguishing the modest economic growth of many developed countries, with perhaps the notable exception of the US although it is yet to be seen whether the pace of growth there is on a sustainable footing or not.

The world owes a lot of money

While no global crisis is ever the same, they all take root in existing vulnerabilities in the economic, political and financial system. In the current recovery, record debt levels, fuelled by a decade of low interest rates, have become a major concern. Since the global financial crisis of 2008, McKinsey reports that total global debt (including household, nonfinancial corporate and government debt) has surged to $169tn from $97tn in 2007. Market attention is particularly focused on the rise of corporate debt in emerging markets, in particular China, which now has one of the highest ratios of corporate debt relative to GDP. For many investors, the fault line lies here. As the US dollar rises, emerging markets have been selling off as local companies struggle to service their US-dollar denominated loans.

Lessons learnt

Emerging markets though are not in the same position as they were 10 years ago for several reasons. While there is a lot of US-dollar denominated debt among emerging market companies, the mis-matching of revenues and borrowing is less pronounced today. There will always be exceptions, but many emerging market companies have learnt from previous crises, and now only borrow in foreign currency where they have foreign currency revenues to provide a natural hedge. Second, the make-up of emerging markets by sector has changed quite markedly with information technology accounting for a much larger proportion of the overall equity universe while the commodities and materials sector now make up a smaller share. As a result, emerging markets would generally be in a better position to weather the decline in commodity prices that would generally accompany a global slowdown. Finally, there has been a marked improvement in capital management and alignment with minority shareholders, reflected in the much higher proportion of companies paying a dividend today than they did a decade ago.

Set against these positives, sceptics might point to the crises in Turkey and Argentina as trigger points for broader global contagion. So far, this has not been the case. Turkey has always been an outlier in terms of its vulnerability to external crises due its large current account deficit. Similar crises, albeit on a smaller scale, have occurred before without much in the way of contagion. As for Argentina, a new austerity programme is a step in the right direction to restore faith in the economy with international lenders. Yes, emerging markets have sold off but we are not seeing a Domesday scenario playing out.

Disruptive politics and politicians

The Turkish crisis in fact points to a different vulnerability that has emerged since the global financial crisis: the role of politics as a disruptor of global growth. The threat has always been present but appears more acute now than it ever has. In Turkey, power is concentrated in the hands of one man, Recep Tayyip Erdogan, a demagogue with unorthodox economic views that have contributed to his country’s current crisis. Over in Russia, the economy struggles as Vladimir Putin’s de facto annexation of Crimea, his country’s alleged meddling in the US elections and involvement in Syria have sparked a raft of international sanctions. In the UK, economic growth has slowed since Brexit while the election of Donald Trump and his policy of America First have led to a tit-for-tat trade war with global growth the most likely victim. Geopolitical friction can easily escalate and needs to be monitored carefully.

When trying to predict the next economic crisis, a fool’s game at the best of times, one could do worse than consider the wise, if possibly apocryphal words of Mark Twain that “History doesn’t repeat itself, but it does rhyme.” Yes, we will see future global shocks but banks are unlikely to be the culprit. They have largely smartened up their act over the last decade. New challenges and new risks though have come to replace them. We have seen, for instance, massive growth in passive investing and algorithmic trading and at this stage we can only guess how they might behave in stressed conditions.

Ten years on from Lehman, financial markets are still learning to operate in the new environment created by the financial crisis of 2007-08 at a time when the world has continued to increase in complexity. The ability of people to understand financial and real-economy interlinking has, in my view, seen little improvement. In 2008, Queen Elizabeth II visited the London School of Economics and asked why nobody had seen the financial crisis coming. Were we to be the subject of another global shock, I fear Her Majesty may find herself asking the same question.

Edward Bonham Carter , September 2018

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