Lehman Brothers – 10 years on: the policy response

Phil Milburn, Olly Russ, James Inglis-Jones, Anthony Cross & Jamie Clark

In the second of a three-part series to mark the 10-year anniversary of Lehman Brothers’ collapse, Liontrust fund managers discuss the policy response to the Global Financial Crisis (GFC), the impact on capital markets and the outlook now as the emergency policy measures for developed markets are being withdrawn.

The collapse of Lehman Brothers on 15 September 2008 was a symbolic moment in an escalating GFC. As the fallout broadened, government and central bank intervention was required to effect a number of bank bailouts, provide emergency funding and to engage in coordinated global monetary policy stimulus.


From a starting point of 5.0% in September 2008, the Bank of England had cut rates to 0.5% by March 2009 while the European Central Bank slashed its refinancing rate from 4.25% to 1.25% over the same period (and continued to cut all the way down to 0% by 2016). The US Federal Reserve had already slashed rates to 2.0% from 5.25% a year earlier, and by the end of 2008 had cut rates to a range of 0% - 0.25%, where they would remain for seven years.


In November 2008, the US Federal Reserve also unveiled a bond-buying quantitative easing (QE) programme, which was replicated by the Bank of England in 2009 and, belatedly, the European Central Bank (ECB) in 2015.


How would you characterise the policy response to the Global Financial Crisis?

Phil Milburn, Global Fixed Income team: The bailout of the financial system by the public purse with programmes such as the US Troubled Asset Relief Program (TARP) ensured that the credit market survived. Without state intervention, the whole of the financial system would almost certainly have collapsed. 


Olly Russ, European Income team: From a central bank perspective, the unanimous response globally to the lacklustre global recovery after the financial crisis was to cut rates and pursue various forms of QE.

During the last decade, we have been bombarded with phrases such as ‘lower for longer’, in reference to the outlook for interest rates, and ‘whatever it takes’ in respect of the ECB’s approach to supporting the eurozone economy. In fact, in the immediate aftermath of the UK’s Brexit vote, it was felt that ‘zero forever’ was rapidly becoming market consensus!

How did this affect the investment environment?

James Inglis-Jones, Cashflow Solution team: The global financial crisis effectively ushered in an era of investor dependency on central banks to drive risk appetite.

Anthony Cross, Economic Advantage team: Accommodative policy certainly aided the recovery in stock markets in the years following the GFC.


One of the most interesting aspects of the rally was that it included distinct bouts of ‘risk-on’ investor behaviour during which companies with low-quality balance sheets were actively sought out. The very companies who had been most distressed as the credit crisis and recession escalated were seen as those most likely to be the biggest beneficiaries of loose monetary policy and improving sentiment. ‘Dash for trash’ is a phrase which very succinctly conveys this risk-seeking behaviour.


James: Another term used to describe the investment environment was “a rising tide lifts all boats”, as asset price inflation pushed markets higher. However, during large chunks of 2012 and 2013, it was often actually the case that the least seaworthy boats were lifted the most!


Through the prism of our Cashflow Solution process, this effect manifested itself through valuation compression, by which we mean that shares in poor-quality distressed companies were bid up to artificially high multiples, while solid growing companies were not afforded the premium valuation their superior balance sheets and prospects usually command.


Was this effect a headwind throughout the decade?

James: No, not really. The phenomenon really peaked in the aftermath of ECB President Mario Draghi’s defining “whatever it takes” speech in the summer of 2012. Investors were already becoming accustomed to policymakers providing fresh stimulus at the first sign of a weakening of sentiment, and this comment cemented the perception that central banks were underwriting markets. This, in turn, encouraged indiscriminate buying of risk assets.


It’s worth clarifying that this behaviour was only a headwind in the relative sense. Equity markets made strong gains during these years, a rally which it was easy to participate in but harder to generate alpha against due to the indiscriminate nature of the gains.


In recent years, the bull market has seen steadier progress and this has provided a much more benign environment for our process to add value.


Anthony: The very sharp ‘risk-on’ bouts in the years James highlights – 2012 and 2013 – were frustrating for us. We seek to invest in high-quality companies whose prospects for growth and strong financial performance, while boosted by better economic conditions, are not reliant on them. However, ‘stronger’ companies, which by their nature are less dependent on policy assistance, were relatively out of favour during these periods.


Outside of these episodes, the backdrop for stock selection has been much more positive.  Fundamentals have gradually reasserted themselves over time as swings in investor sentiment have subsided somewhat.


Olly: One side-effect of the huge bond-buying QE programmes which has persisted throughout the decade has been a smothering of market volatility. A steady stream of money was being pumped into capital markets, inflating asset prices and smoothing out the periods of volatility one would usually expect to experience.


One of the European Income investment strategies involves enhancing portfolio income by writing ‘covered call’ options on some holdings. The low implied volatility levels consistent with significant investor complacency meant that the level of premium income one receives for writing calls was (and is) – on the whole – not hugely attractive by historical standards.


A decade on, these policy measures are now being withdrawn. What is the market outlook as policy normalises?

Phil: Although interest rates are not going back to their pre-GFC levels, a withdrawal of some monetary stimulus simply has to happen. There are differing paces of normalisation around the world; the US is leading the way, whereas Mario Draghi has signalled that eurozone rates will not increase until after the summer of 2019.


Traditional bond market correlations have been distorted by central bank buying, so the reassertion of factors such as the inverse relationship between credit spreads and government bond yields is a welcome development.


In ‘normal’ times, positive economic growth data might push government bond yields up on expectation of higher rates while, at the same time, credit spreads tighten due to improving prospects for the corporate sector (i.e. lower yield risk premia required) – an inverse relationship. However, central bank intervention involved bond-buying across the board, which pushed prices in the same direction.


There should now be far more volatility in bond markets and managers who focus on alpha (outperforming positions) are likely to thrive compared to those who are just beta (generic market exposure) junkies. At risk of overdoing the market clichés: just as the proverbial rising tide of monetary policy lifted all ships, when this tide goes out we will see who has been swimming naked. Individual company selection will garner greater importance in a credit market that is entering a late cycle phase. Government bond risk throughout Europe should generically be avoided but there are now small positive real yields in the US.


Olly: At the very least, it seems likely that the very low levels of market volatility experienced over recent years seem set to rise as QE programmes end.


Rising interest rates and bond yields could also potentially impact every investment decision, from which asset class, to which region, styles, sectors and even stocks investors should select. If we accept that rates might be moving higher – but not too far – there is a strong correlation between rising rates and the outperformance of ‘value’ over ‘growth’.

Jamie Clark, Macro-Thematic team: We also expect unloved ‘value’ companies to thrive. Strength in value typically coincides with rising inflation expectations and bond yields, and economic normalisation promises both. From cash-generative miners, to financials reliant on bond income, this explains why our portfolios currently have a broad bias to value.


The post-crisis decade of easy money has been a boon to ‘growth’ stocks. Low rates mean a lower cost of capital, or discount rate. Under such conditions, discounted cash flow analysis ensures that growth stocks’ promises of jam tomorrow are worth more today. Higher rates put an end to this.

Bond-proxies should also suffer. Their characteristic stability of earnings has been at a premium in an era of low rates and disinflation. Economic normalisation is a watershed.

James: We also need to be aware that we are 10 years into a bull market. This has pushed aggregate valuations to levels which are high relative to history. We are also starting to see some signs of investor complacency and corporate over-optimism. Higher rates and a cessation of QE have both been justified by economic improvements, but I feel it’s only prudent to sound a note of caution that the risk of policy error – while small currently – is one possible catalyst which could uncover some underlying fragility in the current stockmarket uptrend.

Next week: What lessons have Liontrust’s fund managers learnt in the 10 years since Lehman Brothers’ collapse?

Last week: the GFC and its impact on the banking sector.

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Friday, September 7, 2018, 8:50 AM