The global economy has moved on from the financial crisis, but how many of the imbalances that it helped generate persist today?
A decade has passed since the collapse of Lehman Brothers and the ensuing financial crisis. The S&P 500 lost more than $5 trillion, a 54% drop in market capitalisation, between the demise of Lehman Brothers in September 2008 and March 2009.
In 2008, the US government was forced to put the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp, which combined owned or guaranteed about half the US mortgage market, into conservatorship. This led to a 5.3% slump in global GDP, the steepest decline in the post-war era. This 10-year anniversary coincides with a decade-long period of US expansion, and the longest bull equity market since the Second World War. Which poses the question – 10 years on, have we now fully recovered from the worst financial crisis since the Great Depression?
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The scale and breadth of the crisis prompted central banks to adopt aggressive and unorthodox monetary policies in tandem with governments deploying a mixture of austerity and fiscal measures. A decade on, the US economy is 40% larger than it was in 2008, with record corporate profits and unemployment falling to a 50-year low, while the S&P 500 has increased fourfold since its nadir in 2009.
High street banks and consumer leverage were behind the crisis, and both segments have recovered sharply, with debt-to -income levels in US households at a 40-year low compared with a 40-year high in 2006.
Banks have lowered their reliance on short-term funding and shrunk their balance sheets. The banking sector on both sides of the Atlantic has more than doubled the core Tier 1 ratios, in large part driven by regulation.
The deep intervention by central banks through low interest rates and quantitative easing has been pivotal in helping to inflate all asset classes – bonds, equities and real estate.
Global central banks cut interest rates more than 700 times since September 2008. However, this comes at a price, as the intervention in large parts has led to an unprecedented debt binge. The tally for global debt is now closer to $250 trillion, of which total government debt is more than $65 trillion, up from $37 trillion a decade ago.
The US, China, the eurozone and Japan account for two-thirds of the world’s household debt, three-quarters of corporate debt and 80% of government debt.
The US treasury market has trebled since 2008 to more than $15 trillion and non-financial corporate debt is now 90% of GDP, up from 78% a decade ago.
Japan’s unprecedented asset purchase programme has resulted in the Bank of Japan’s holdings surpassing the country’s annual economic output. The number for the US is 20% of GDP, while the European Central Bank’s holdings are approximately 40% of the Eurozone economy.
The rest of the world hasn’t escaped, with central banks in emerging markets holding higher levels of debt than in 2008. China’s debt has ballooned in the post-Lehman Brothers era to $40 trillion from $7 trillion previously.
Since the crisis, financing of this mountain of growing debt hasn’t been an issue, owing in part to low inflation and a strong global demand for safe US Treasury bonds, which has checked interest costs.
However, this is in the process of changing, with the US Federal Reserve well on the path of rising rates, which will have a material impact on government spending priorities and, in turn, financial markets.
In the next five years, approximately 70% of federal debt will mature and need to be refinanced, probably at higher rates. The interest cost on federal debt is projected to more than double to more than 3% of GDP from 1.4% in 2017.
To put that number in perspective, the US government will spend more on servicing interest payments than it will spend on Medicaid in 2020 and national defence by 2023.
The US Treasury is forecast to issue twice as much debt as it did in 2017 and the recent tax reforms enacted by the Trump administration will only add to the budget deficit, leading to greater pressure on borrowing going forward.
Although certain parts of financial markets have deleveraged – financials and households – US corporates have done the opposite, taking advantage of low interest rates and heightened demand in the QE era.
Companies in the US have issued a record amount of debt, with corporate debt/ GDP and debt/ EBITDA both rising to near 20-year highs. This has led to a marked decline in credit quality with BBB’s now making up the largest part of the investment grade market.
While financials have embraced new regulation, and tightened lending criteria are going some way to mitigate a repeat of the crisis in 2008, there is greater risk of unchecked corporate leverage being at the core of the next crisis.
The increased levels of regulation enacted post-crisis have left the financial system in a stronger position than a decade ago, with higher capital buffers and stable funding.
However, this is coming under threat with the risk of deregulation under the Trump administration in the US, and could spread to other developed economies.
While we would argue that we are not completely out of the current crisis entirely, the danger that is facing the financial system is the limited toolkit available to policymakers when the next crisis presents itself.
Ketan Patel, fund manager of the Amity UK Fund at EdenTree Investment Management.