Thursday 6 December 2018 8:21 am

We have paved the way for the next financial crisis

Bill Blain is market strategist and head of alternative assets at Shard Capital. He writes a daily market commentary called The Morning Porridge

Optimists believe that the last decade of roiling financial crisis and austerity is behind us, and that current fears of trade war, Brexit, populism, and market crashes are overblown.

They hope for a global economy poised for many years of growth, increasing personal wealth and prosperity, and political stability.

Sadly, hope is never a strategy.

Realists, on the other hand, fear that unstable and troubled bond and stock markets won’t abate anytime soon, and that the unintended consequences of solving the 2008 financial crisis could ensure that the next one is even worse.

Why? Let’s start with regulation.

Since 2008 many things have changed. The evolution of financial markets since the crisis has been less than optimal.

Politicians and regulators were swift to enact rules to address the perceived root causes, such as mortgages, bank capitalisation, and risk-taking.

Higher capital levels have made banks look cosmetically safer, but at the same time, increased costs of capital, the regulatory burden, and compliance-slavery have caused them to pull back from providing liquidity through market making.

Firms were forced to cut costs and staff, meaning that the average tenure of fund managers today is less than eight years. Most bank trading and sales desks are staffed by graduates. Markets have no memory, because a whole generation of experience has been dumped and lost.

In addition, new draconian capital rules have encouraged banks to exit high-risk lending, transferring risk from banks to non-banks – including pension funds, insurance companies, hedge funds, and other investors, where the skills and expertise to manage complex risks don’t necessarily reside.

Risk has not gone away – it’s just no longer sitting with the banks.

Then we come to quantitative easing (QE). The key policy of central banks post-2008 was to pump-prime economies through zero interest rates. The unintended consequences of these monetary experimentation policies has been to trigger enormous pricing distortions that are only now beginning to make themselves clear.

As central banks hoovered up bond markets, savvy investors simply arbitraged their activities.

Rather than zero-rates causing companies to build new factories and infrastructure to drive activity and create jobs, most simply borrowed more from bond markets and spent it buying back their own stock – pushing up the value to owners, while rewarding executives with higher bonuses as stock prices soared.

Now that rates are rising again, corporates find themselves over-levered and less credit-worthy.

General Electric, once the most valuable and US-AAA-rated corporate, spent $26bn buying back its stock. It is now rated just above junk, while the stock price is 75 per cent lower.

As government bond rates fell close to zero, fund managers were forced to take greater and less familiar risks to maintain returns.

This became known as yield tourism. The cumulative result is that investors generally hold greater risks for less return. The costs of unravelling QE are going to be enormous, considering distorted prices, hidden inflation, constrained wages, and conflated debt with equity. It is likely to be messy.

Finally, there’s the politics element.

Alongside QE came austerity, as countries were forced to bail out bankers, rescue failing lenders, and cut social spending. An immediate result was unemployment and recession. The long-term effect has been a voter shift towards populism, based on the perception that QE made the rich richer while austerity made the poor poorer.

It is no surprise voters that across the developed world have sought someone to blame and embraced populist politicians promising better conditions as conventional politics failed.

Barack Obama’s failure gave us Donald Trump. David Cameron’s failure led to Brexit. Matteo Renzi’s failure paved the way for Italy’s Northern League and Five Star Movement. Angela’s Merkel failure has given the whole of Europe chaos, and Emmanuel Macron’s failure could soon give us Marine Le Pen.

The continuing rise of populism means that the likelihood of enormous policy mistakes has never been higher. Trump’s trade spats, the uncertainty of the current deal with China, and his threats to bring down European carmakers are just one example of the risks of populist policy.

And those risks are escalating in Europe too, as Italy squares off against the European Central Bank, Germany faces a populist right-wing revolt causing it to pull back on further integration, while Brexit has become a matter of “being seen to win” rather than doing the right thing on both sides of the divorce.

You can’t fault voters for wanting better and falling for the appeal of populism. But the stakes are high.

Markets are about politics and sentiment. And that is what the realists under stand, watching with concern to see how financial difficulties and declining sentiment (exacerbated by a trifecta of rising interest rates, declining stock markets, and political upheaval) could magnify into a serious financial crisis.


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