The global economy appears to be humming along 10 years after the collapse of Lehman Brothers, a defining moment in the global financial crisis. Many problems exposed then have been addressed, giving us confidence that the odds of a repeat of a similar crisis may be low. Yet new risks and some old ones deserve investors’ attention.
We illustrate the dynamic by showing leverage in different parts of the U.S. economy in the chart above. Debt levels in the household and financial sectors have both declined from pre-crisis peaks. Recall that high leverage in those two sectors was at the center of the global crisis. The leverage in the financial sector, represented by the asset-to-equity ratio among security brokers and dealers, has also decreased. New risks? Sovereign and non-financial corporate debt is on the rise. Government debt has jumped to nearly 94% of U.S. GDP from 52% in 2007–and is headed higher. Leverage among non-financial corporates has exceeded the pre-crisis level after a period of decline. What’s more worrisome is that it is a global phenomenon. The silver lining: Lower interest rates make the cost of servicing this debt much cheaper than a decade ago, and maturities have been lengthened, providing resilience to rising rates.
Proceeding with caution
We have come a long way since 2008. Banks have larger liquidity buffers, are better capitalized and under greater supervisory scrutiny, though European banks have made less progress than their U.S. peers. The global financial system in general is on a firmer footing thanks to post-crisis regulation that has bolstered the ability of financial institutions to absorb shocks. The lack of extremes in markets, such as very high valuations and very low risk premia, is even more encouraging. We do not see excessive investor crowding in risky assets. The last financial crisis amplified an aversion to taking risk, resulting in higher precautionary savings.
The caveats to this rosier picture? The Federal Reserve and European Union (EU) authorities now face legal limits in their ability to rescue troubled banks. Monetary policy has less room to maneuver with global interest rates still at historically low levels and some major central banks yet to start winding down their post-crisis asset purchase programs. Sovereign debt loads have ballooned, curtailing the scope for fiscal stimulus. There has been greater concentration of assets in the largest banks, and those with cross-border operations would be no easier to resolve in a doomsday scenario. Central counter party clearing houses have helped boost transparency in derivatives trades–the lack thereof was blamed as a trigger of the last crisis–yet their ability to weather a crisis is untested. Reduced market liquidity creates the risk of spillovers if investors are forced to sell the more liquid parts of portfolios. High corporate sector debt and opaque lending in China are potential sources of financial vulnerability. And the concerted global efforts required to contain the last crisis may be harder to come by for the next one amid a global wave of populist and nationalist sentiment.
The vulnerabilities that plagued the global financial system a decade ago have been reduced–but have not disappeared. Coupled with rising macro uncertainty, we believe this warrants a heightened focus on portfolio resilience. Yet overall we retain a pro-risk bias–and believe investors are being compensated for the equity risk they take in today’s environment of steady growth and strong corporate earnings.