The next crisis

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A decade on from the global financial crisis, fears are being expressed that another crisis could be in the wings. InvestmentEurope reports.

What is in a gap? Quite a lot, according to well-known economist Nouriel Roubini, who noted in early August on the anniversary of the first six months of the Trump presidency that although stock markets had continued to climb the US economy grew at an average annualised rate of just 1.9% in the first half of 2017.

This is a problem, he commented for Project Syndicate, in that it points to a widening gap between “Wall Street and Main Street”.

From early November 2017, when Trump was elected, the S&P 500 went from around 2,080 to 2,480 by early August 2017.

The Russell 3000 went from about 1,230 to 1,460 while the Nasdaq 100 rose from 4,660 to over 5,930 over the same period. Over in a totally different asset class, the Federal Housing Finance Agency house price index tracking single family houses showed a 6.63% change on the previous four quarters, as of the end of Q2 2017.

But, does this gap between asset values being driven by investor bets and what is happening to broader economic growth suggest an imminent crisis?

TEMPLETON’S WISDOM
There are signs. In London in the week of 21 August, sub-prime lender Provident Financial saw 60% wiped off its share price in one day following a profits warning.

But Mihir Kapadia, CEO and founder of Sun Global Investments says it is a complex question to answer.

“The current rally in risk assets started in March 2009 and has been described a stealth rally, and many investors have been sceptical about it because the memory of the global financial crisis and the 2008 crash was very strong, and remains so today,” he says.

“As Sir John Templeton said: ‘Bull markets are born on pessimism, grown on scepticism, mature on optimism, and die on euphoria’.

The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell. The problem here is how we determine that we are at the point of these maxima.

“We have optimism and complacency but have not seen great euphoria in this bull market. Euphoria is difficult to define, but it is when everybody is bullish (the last bear has thrown in the towel) and is fully invested and perhaps on leverage etc., and when everybody believes the markets can only go up. This euphoria usually marks
the peak of most bull markets. We are currently not in this period though we should be looking for signs of this.”

FINDING VALUE
Another more sanguine view comes from Daniel Nicholas, portfolio manager at Harris Associates, an affiliate of Natixis Global Asset Management, who notes that despite the strong returns over the past year, it is still possible to find value.

“As value investors, we must be disciplined to focus on business value rather than stock prices. When prices drop for no fundamental reason, this approach gives us the conviction to hold or even add to assets when others are fearful.”

Sergio Cano, fund manager at Gesinter, agrees that there are certain indicators that investors do need to keep an eye out for.

“When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall. Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession which is seen a year before.”

THE DEBT QUESTION

One thing that central banks and economists keep an eye on is levels of debt. Systemic instability was amplified during the global financial crisis because of excess leverage in the financial system.

But also consumer debt; unsurprising when mature economies are so dependent on consumption. Guy Stephens, technical investment director at Rowan Dartington noted that while it might seem considerate of central banks, such as the Bank of England to sound warnings over levels of consumer debt, it also presents a contradictory message.

“We find the Bank of England’s current concern surrounding rising consumer debt levels somewhat contradictory; on the one hand, it is trying to encourage spending, while on the other it is growing concerned about rising debt levels. However, it is this loose policy that has allowed people to borrow at ever cheaper rates. This in turn gets spent within our very service based economy, thus contributing to our positive GDP growth figures.

“The average long-term base rate of the Bank of England is around 5%, with variable rate mortgages around 2% higher and personal loans some way above that. While we are a long way away from seeing interest rates this high, it is easy to see the mounting concern that some analysts are having.”

In Sweden, where the repo rate applied in early July was negative at -0.5%, the Riksbank stated that it did not see repo rates turning positive before mid-2018.

In the meantime, it will continue to buy government bonds. Globally, inflation pressures are still dampened it noted. Crucially, the bank also reiterated that its policies had contributed to a strong economy and rising employment.

Further policy direction signals would be expected to arise out of the annual Jackson Hole summit in the US, where central bankers gather each year towards the end of August.

SELECTORS’ VIEWS
Carim Habib, managing partner of Dolat Capital in Lisbon, picks up on the debt question, but notes that:

“In the US, we witnessed in the last couple of years both a high yield bonds short term crisis, as the price of oil dropped, and more recently an auto lending crisis, involving Santander and other banks. These have been resolved, and despite a short period of volatility, did not cause a major impact in global markets, as the banking system is now more robust.

“However, there are signs that markets are complacent. For example, junk bonds in Europe have a similar yield to US Treasuries. We are worried that the global tapering of central banks might cause a spike in volatility in these bonds and consequently a repricing of these assets to ‘normal’ levels. This would be a strong movement of repricing risk which would be extended to other assets and could even lead to a strong market correction in equity.”

Another view explained by Habib, is that although a ‘crisis’ may broadly be considered a negative development, should it appear then it may actually lead to more opportunities to find value, at a time when market participants fear owning riskier assets.

“Consequently, we do not try to predict exactly when the next crisis will happen. Notwithstanding, we use several indicators to understand how stressed is the market and where the next crisis might come from,” he says.

These include “the level of non-performing loans in the banks, the level of debt in companies, the default ratios (both corporates and sovereigns), house market price rises, unemployment level and Tobin’s Q – the ratio of stock market value by total corporate net worth.”

“In terms of market indicators, we usually monitor CDS levels, equity market volatility (VIX), commodities prices, historical P/E ratios and as advocated by Warren Buffett, the ratio between market capitalisation of the stock market and GDP, which when higher than 1, signals stretched asset valuations.

“Political risk usually develops very fast and it is unpredictable sometimes. Currently our attention is focused on president Trump’s external relations, especially with China, Russia and North Korea, and on German elections. Polls suggest a victory from chancellor Angela Merkel’s party (Merkel’s party has won the elections), however, terrorism, refugee crises and hackers may threat her lead.

“We believe that a crisis is very hard to foresee, and even harder to time. Besides constantly monitoring these indicators, we deem diversification and the use of safe haven assets – such as gold or yen – as focal points to build a balanced portfolio that will robustly endure market stress when a crisis materialises.”

Roni Michaly, CEO and head of Fund Selection at Financière Galilée looks at two indicators in particular to gauge the risk of a financial crisis: the interest rate and volatility curves.

“A reverse move or a flattening move that can lead to a reverse trend can be spotted on both curves when a crisis seems eminent,” he says.

“As for now, I do not stress any of this. A lot of efforts have been made in developed countries since 2008 to prevent the conditions for a new global crash. Macro-economic indicators seem rather positive and companies’ earnings, although slightly disappointing, do not raise concerns.

However, big question marks remain such as Chinese companies’ real levels of debt and shadow banking practices in certain emerging markets including China which could be potential factors of instability.

“The level of household debt seen in developed countries does not yet appear as an eventual trigger of a crisis. We have heard of the US student loan bubble that has been depicted as the new subprime crisis. It is not the same market in terms of size and of consequences it could have on the financial ecosystem. Pricing models are not running mad as was the case in 2008 with credit default swaps or collateralised loan obligations. Also, economies are pretty much in good shape. A brutal crisis appears unlikely to occur.”

Camille Barbier, chairman and head of Fund Selection at Salamandre AM shares the view: “I do not believe that a crisis is around the corner.”

Barbier cites two reasons for holding this view: “Except for a handful of cases, macro-economic indicators such as GDP growth perspectives look very good worldwide.

The regions in which the broader picture is not improving are rare and it is likely that their problems are linked to local issues. These indicators won’t reverse dramatically from one day to another.”

Sébastien Gyger independent financial adviser at Gyger Advisors has a similar outlook, suggesting that there is little risk of another crisis.

“Quite the contrary in fact, as the economic and financial landscapes are pointing towards a continuation of this equity bull market.”

Gyger takes particular umbrage with the notion that markets are overvalued.

“Apart from the fact that valuations have never been a reliable indicator at timing the market, with a 5% median earnings yield, global equities, including emerging, are reasonably valued, both from an historical perspective and in absolute terms. Most notably, earnings have been coming through over the past 12 months and have kept pace with the market advance, globally. Coupled with sustained global economic breadth and monetary conditions that remain accommodative, this market has further to go.”

LESSONS FROM THE PAST
Marta Campello, partner and fund selector at Abante Asesores adds that prior experience of the global financial crisis can help in the current environment.

“Let’s begin by saying that anticipating market crashes is quite a difficult thing to do, but regarding the 2008
crisis there were several lessons every fund selector must remember:

• Always perform a deep analysis of the fund: investment process, instruments, the team, etc. Do not skip any of the steps of your due diligence.

• Demand transparency and stay away from black boxes. • Keep it simple. Don’t invest in funds you don’t understand or funds that have very complex structures.

• Do not fall upon fads. Normally when a fund becomes very fashionable, performances struggle.

• Look for consistency over time. Try to understand why a fund is underperforming in a very short time before having the temptation to sell in the first thought.

• Remember the importance of diversification: asset classes, regions and also, managers, strategies and investment styles.”

Ion Zulueta, head of Manager Selection at Grupo Arcano, picks up on the point made by other selectors that it is very difficult to time a reaction to a crisis before it happens.

“Timing a market crash is possibly the hardest forecasting exercise for the investing community, we are not aware of anybody having found a reliable formula for that. As a second-best option, we prefer to focus our efforts on adapting our portfolios to the existing opportunity set and spread risk across different factors to build an asset allocation more resilient to unpredicted scenarios.”

Referencing government and corporate debt, Zulueta says: “Some of these imbalances have a mainly domestic root like in the case of China, but the financial crisis that could unfold in this country would have global economic and financial implications. As investors, we are worried about the artificially low level of interest rates several years after the global financial crisis, and the economic and financial implications of an experimental monetary policy that has distorted asset prices beyond economic reality.

“2008 was a master class for all investors in the market. Investors increased awareness to the importance of operational risks and liquidity mismatches in the investment fund industry and the necessity to improve the due diligence process.

“We have always thought that it is important to look for fund managers which are not only talented as bottom-up investors, but also are ‘macro aware’ and have proven risk management skills. In addition, we judge portfolio diversification as our first line of defence, which leads us to diversify our clients’ portfolios by risk factors and include alternative strategies like CTAs, that proved very valuable in negative market scenarios like 2008.”

This article was first published in the September 2017 issue of InvestmentEurope.