It's been ten years since Lehman Brothers went bust. Why should I care?
03 October 2018 | Markets and Economy
Commentary by Peter Westaway, Vanguard's chief economist in Europe and head of our European investment strategy team.
Ten years ago, I remember watching the footage of the collapse of Lehman Brothers, seeing employees emerging from skyscraper offices in London and New York carrying their boxes of possessions. I didn’t know then that I would end up working in one of those buildings, One Bank Street at Canary Wharf, when I joined Nomura, the Japanese investment bank who bought the remains of Lehman’s failed European operation.
Ten years on, I am working at Vanguard, and I am considering whether Vanguard’s investors should take any notice of the anniversary of this event. The sheer number of emails providing retrospective analysis of the lessons learned suggests it was important. And indeed, much of it is really interesting for economists, for students of economic history and for policymakers who need to ensure that a similar crisis will be avoided in future. But most investors don’t care about sub-prime mortgages, collateralised debt obligations or macro-prudential policy measures.
Instead, what investors care about, and what I want to focus on, is why all this still matters for investors today.
Everyone was affected by the financial crisis. As the financial system went into meltdown, real economic activity slowed sharply. In the end, GDP fell by around 6%1 (the decline actually began during 2007) and didn’t recover its pre-crisis level until 2013. The chart below shows the impact on the financial markets, with the FTSE All-Share Index falling some 35%2. These losses were clawed back by 2010. Since then GDP has grown by a further 10% while equity prices have risen by a whopping 70%. It would appear the impact of the financial crisis is behind us and we don’t need to think about it anymore.
UK GDP and FTSE All Share, 2007-present.
Source: FTSE, U.K. Office for National Statistics (ONS)
Macrobond - 9/14/2018
Not quite! One of the main reasons the real economy recovered as it did, globally as well as in the UK, and the financial markets rebounded so spectacularly is because of the considerable policy stimulus undertaken by policymakers, particularly by central banks. Over a period of months, interest rates around the world were cut to unprecedentedly low levels, sometimes into negative territory. And many central banks augmented these cuts with quantitative easing measures which boosted global liquidity still further. All these steps had the effect of raising the demand for financial assets, and for risky financial assets in particular. As a result, despite all the doom and gloom in the headlines, asset prices soared and returns for investors were spectacular. An investor's holding of £1000 in UK equities at the market peak in late 2007 would have grown to £1732 (an annualised growth rate of 4%).
This narrative still matters because we have now reached the point where policy stimulus is being removed; already in the United States, more gradually in Europe. The punch bowl is being removed just as the party was starting to swing. This is important for investors to consider. Interest rate increases will put downward pressure on fixed income returns. And equity returns are likely to be depressed as the central bank asset purchases unwind. Based on Vanguard Capital Markets Model we estimate the median expected return on a balanced portfolio of UK and global equities for the next 10 years to be around 4% per annum, a far cry from the 8% p.a. earned over the last 10 years (and certainly less than the 13% per annum earned since the trough of the market). That 4% is only an estimated average. But in the real world, when markets are overstretched as they are currently, the chances of a more severe market correction are elevated. Any number of economic shocks might act as the trigger for that market correction; Brexit, trade wars, emerging markets crises, Fed over-tightening, a hard landing in China, and so on. We estimate that a fall in our globally balanced portfolio of equities of 20% (the technical definition of a bear market) over the next 5 years has a likelihood of around 1 in 7 over the next five years; that’s around three times higher than the chances under more normal circumstances.
Is this a clarion call for investors to make radical adjustment to their portfolios to circumvent these risks? No, quite the opposite. When markets are volatile calm heads should prevail. Our research shows that during market downturns, impetuous investment decisions can cause investors to make costly mistakes. The temptation to try to time markets is great. But in practice, investing isn’t so simple. Many investors shy away from risky assets following a market downturn and by the time they are ready to reinvest, the rebound has occurred, the opportunity has gone and the protracted period of low returns suffered will add to the losses from the original downturn. Now more than ever, there are compelling reasons to stick to a plan, to exploit the advantages of low-cost globally diversified portfolios and stay invested for the long term.
1 Source: Office of National Statistics
2 Source: Bloomberg
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