Commentaries

PMC Weekly Review - August 11, 2017

A Macro View: When it comes to crisis, hindsight isn’t always 20/20

Wednesday marked the 10th anniversary of the start of the financial crisis that led to the Great Recession. Many agree that what started the domino effect that brought global financial markets to their knees is the BNP Paribas Investment Partners news release on August 9, 2007. The carefully crafted message relayed that the bank was suspending withdrawals from three of its multibillion-dollar hedge funds that specialized in US mortgage debt, due to a “complete evaporation of liquidity in certain market segments.” This little news release spiked short-term interest rates for lending money to banks and completely shut down the market for financing asset-backed securities deals. A year later, investment bank Lehman Brothers collapsed, and the global economy embarked on the worst recession since the Great Depression. 1

Economists still don’t agree on the causes that brought down the financial system. MIT economist Andrew Lo plowed through twenty-one books on the financial crisis—eleven written by academics, and ten authored by journalists and one former Treasury Secretary. Yet, he couldn’t conclude that one single story fully explained what happened. Even in the best of circumstances, understanding the crisis would be difficult, Mr. Lo writes. The most important observation according to him is that “…there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it.” He goes on to conclude that today’s economists face great challenges caused by the growing complexity of the financial system. 

Where do we stand today? Many of the deficiencies believed to have contributed to the financial crisis, such as reckless risk-taking by bonus-driven investment bankers, complicit credit-rating agencies, excessive leverage in the banking system, and out-to-lunch regulators, have now been addressed by governments and regulatory agencies. It has taken a full ten years since the onset of the global financial crisis for the world economy to show clear signs of recovery. We can thank extremely accommodative central banks’ policies and incredibly low interest rates for today’s brightened global economic outlook.

Despite these points, there is a growing chorus of analysts and investors that speaks of similarities in the state of the financial markets and economy between then and now, and worries that history may be about to repeat itself. According to Capital Economics, although similarities exist between today’s state of the US economy and financial markets and what they were back in 2007, high valuations in equity markets are the result of a secular decline in real interest rates.2 Yet, in his most recent memo, famous investor Howard Marks, of Oaktree Capital, noted that today’s investment environment is characterized by unusual uncertainties “in terms of number, scale and insolubility” in areas such as secular economic growth, political dysfunction, geopolitical  risks, impact of central banks, etc.3 Add to this list high asset prices across the board and commonplace pro-risk behavior fueled by a spread-out eagerness to put money to work, and the result is a highly challenging investment environment, he noted. Economists continue to disagree on the state of the markets, the economy, and what could trigger the next crisis, and although fears of a tsunami in the financial markets may be overblown, we expect to see an increase in volatility in the coming months, given the historical low levels we are experiencing currently. 

So, what’s an investor to do in the face of increased market risks? Stay in the markets, or run for the exits? First and foremost, one of the most important things an advisor can offer clients is a solid, diversified investment portfolio based on a strategic asset allocation that is tailored to the client’s long-term investment needs and goals. Absent a crystal ball that would tell us exactly when to exit, and most importantly, re-enter, the markets, it becomes vital to emphasize to clients the importance of staying invested. Although it is easy to panic and run for the exits when the markets tumble, a growing body of research has shown that timing the markets can be nearly impossible to do profitably, and staying invested can help produce positive returns over the long term. 

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1Journal of Economic Literature 2012
2Capital Economics Research
3www.oaktreecapital.com

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Sonila Gjata, CFA
Assistant Vice President, Portfolio Manager

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PMC Weekly Review - August 11, 2017