While market turbulence is far from new, recent weeks have raised fresh questions about the similarities between current events and the 2008 financial crisis. There are certainly some similarities:
- Although both now and in 2008 there were warning signs of a potential looming crisis, it was an arcane part of the financial markets that became the focus of the storm. In 2008 it was the packaging of mortgages into collateralised debt obligations (the CDO and CDO squared products) that brought banks to the brink, while at the moment it is (in the UK) the exposure of life insurers’ liability driven investment strategies (LDIs) that has now entered common parlance.
- Second – a common thread to all such crises – is the fact that, once gone, liquidity and confidence can rapidly result in a ‘death spiral’ for market participants. We are currently witnessing UK pension schemes all having to liquidate gilts as a consequence of their LDI strategies which has forced government intervention on a huge scale.
- And of course, both these events have been the culmination of unfavourable macro-economic circumstances which, as hindsight will surely assert, makes them ‘predictable’.
But there are also real and important differences:
- Cross-contamination – the potential crisis in the UK should have no spill-over to other economies, or at least only indirectly. By contrast, the collapse of the sub-prime market in the US had a huge, global, impact.
- Regulation – in 2008 there were significant gaps in both the oversight of financial products and the way that banks were capitalised, which caused a ripple effect across a multitude of users. The subsequent regulatory agenda meant that there is, hopefully, very little contagion risk in the market at present. The Solvency II rules for asset managers should ensure their ongoing stability, although the jury is still out as far as the life insurance and pensions industry is concerned and their exposures to illiquid and junk assets. Expect some new guidelines on these matters.
- Recession – the financial crisis in 2008 effectively precipitated a recession in many economies and, for many, the financial industry was seen as the cause of the subsequent pain including government bail-outs. Taxpayers will not be bailing out banks this time (indeed we do not anticipate bank failures). In 2022 the reduction in growth and possibility of recession in some countries is a combination of macro economic events, primarily the emergence of inflation and hence a higher interest rate environment.
Given the speed at which events are unfolding, the most important lesson remains: expect change.