Meltdown coming?

21 September 2018

Ten years after Lehman Brother’s collapse, are investors due for the next Great Financial Crisis?

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • What we should make of market commentators who are often predicting recessions.
  • How this economic cycle is different from the previous one.
  • The importance of the post-Crisis increase in corporate leverage.

Impending doom

The 10th anniversary of the collapse of Lehman Brothers seems to have exhumed many of the world’s most committed doom-mongers from their ever shallow graves. Too much debt remains their battle cry, and the end of Quantitative Easing their instrument of the financial/economic apocalypse. Of course, these stopped clocks could be right this time; however, we explore some useful context points for investors below.

Commentary vs. investment

The first and perhaps most important point to make is that there is reputational asymmetry associated with calling recessions. The events of 2008 proved that it doesn’t matter how many times you’ve predicted the end of the world, if you are saying it when the world economy does indeed career over the cliff, your reputation is enhanced. The reverse is true for persistent optimists, in spite of the upwards trajectory of the global economy for the last few hundred years.

Unfortunately for investors, indulging in perennial pessimism tends to come with significant opportunity cost. Those who fell for the last major rash of recession predictions at the beginning of 2016 (when the economy was giving perhaps far greater cause for alarm than it is today) have missed out on substantial returns in global stocks. In this context, a good question to consider when reading such commentary is whether the author has actually put their money where their mouth is? What is their track record, if indeed they have one?

Where are the potential problems vs. the last cycle?

One of the major problems with investing, and forecasting is that it is not just different this time, it is subtly different every time. This dampens the ability of history to provide us with perfect context, even if it can provide useful relief. In the last economic cycle, it was US households and global banks that were the main areas of excessive leverage. This cycle looks entirely different. The debt to income ratio in US households is now at a 40 year low, compared to a 40 year high in 2006.

Meanwhile banks, thanks to a quantitatively and qualitatively different regulatory backdrop, are barely recognisable from their pre-crisis guise. Balance sheets are better insulated, funding is more stable, and oversight is more rigorous and transparent thanks to regular draconian stress tests. That is not to say that there are not banks out there with problems or vulnerabilities, but those who argue that the developed world’s banking sector has not changed its ways are not looking very closely.

However, what we have seen in this cycle is a sizeable increase in non-financial corporate leverage. Companies have used persistently low interest rates to increase balance sheet leverage both in emerging and developed worlds. Within this, quality has declined too. The lowest rated rung, the BBB-rated segment, of the investment grade sector, is now proportionally as large as it has ever been.

Charts plotting the ratio of US non-financial corporate debt to GDP look particularly alarming to the uninitiated. Yet we should probably question how appropriate a denominator US GDP is when talking about the US corporate sector, remembering that these companies are generally competing for a slice of the global pie. The debt figure looks less alarming when quoted as a percentage of corporate profits. When set against corporate assets, we see that leverage has been on a downtrend for much of this cycle, as asset values have grown faster than debt accumulation.

Investment conclusion

None of this is to say that there is nothing to worry about. Of course, there is always a multitude of concerns for investors to ponder. For starters, the details of the future will remain profoundly (and reassuringly) unknowable, however hard we try and mine the past. Meanwhile, the world economy is always contorting and stretching in ways that confound, confuse and provoke those watching. Predicting the precise moment when these contortions come home to roost for the economy and indeed capital markets is far from easy.

We continue to point out that our preferred economic indicators, which have a decent albeit not infallible track record of calling downturns, continue to see no recession on the horizon. That means that we have to find good reasons not to invest in a diversified portfolio – a portfolio that in our view should lean moderately towards stocks in both developed and emerging worlds. We still can’t find those good reasons just yet.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

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