By Morgan Stanley’s chief cross-asset strategist, Andrew Sheets
Anniversaries provide an opportunity to reflect on how things were in the past and how they will be in the future. The passage of 10 years since the bankruptcy of Lehman Brothers is no exception. But given the volume of retrospectives on Lehman itself and the causes and implications of its collapse, we are taking a slightly different approach. Lehman was a reminder that conditions can change quickly and that cycles ebb and flow. What will be different when the next downturn hits?
The first difference ties to an old saying in credit markets: the same sector usually isn’t the problem twice. High bank and consumer leverage defined the run-up to the last downturn, but both segments look very different today. Debt/income levels in US households currently sit near 40-year lows versus 40-year highs in 2006, in part because mortgage lending standards remain materially tighter than pre-crisis. The core Tier 1 ratio for US and European banks has more than doubled over the same period.
US corporates, in contrast, have followed a different path. Taking advantage of low rates and strong demand in the QE era, companies have issued records amount of debt. Debt/EBITDA for US issuers and corporate debt/GDP for the US economy as a whole are both near 30-year highs.
Average credit quality has declined as a result; BBBs now make up the largest share of the ‘investment grade’ market on record.
Taken together, we think this means sharp outperformance in mortgage credit and underperformance in corporate credit when the next downturn hits.
A second difference is liquidity. The growth in sovereign, corporate and EM leverage in the QE era has left these markets significantly larger than were they were a decade ago. The combined USD market for Treasuries, MBS, corporate and EM debt has risen from US$29.8 trillion in 2007 to US$42.9 trillion today.
This much larger market is going through an (arguably) smaller pipe. Aggregate dealer balance sheets remain smaller than pre-crisis, with fewer market makers. This state of affairs has yet to be fully tested in the post-crisis era, but with central bank balance sheet expansion giving way to contraction, it likely will be.
A third key change is regulation. New regulations in the wake of the Great Financial Crisis mean that global banks, insurance companies and asset managers will likely enter the next crisis in a much stronger position than 10 years ago. Capital buffers are higher. Funding is more stable. Oversight is more rigorous, including regular stress-testing of banks in the US and Europe.
That’s good news, because the authorities will have a far more limited toolkit in the next crisis. In the US, rate hikes leave the Fed with room to cut rates if needed. But re-expanding the balance sheet, which still sits at US$4.2 trillion, may be harder. And thanks to recent tax cuts, the federal budget is unusually stretched for ‘good’ economic times, limiting the Fed’s ability to ease further in a crisis.
Europe, interestingly, is in the opposite situation. Assuming a downturn begins in the next two years, current pricing implies that ECB rates would be no higher than 0.10%, with a still-large balance sheet. But the fiscal picture is very different. Sovereign debt/GDP in the eurozone has been declining gradually for a couple of years now.
Those different starting points could mean very different responses to the next crisis. The US’s most powerful tool will be rate cuts. Europe wouldn’t have that option, but could ease fiscal policy aggressively. As discussed in a recent note led by our chief eurozone economist, Daniele Antonucci, we think Europe also has the political will to do this, not just the ability.
If we’re right, these divergent responses could mean very different FX trajectories. The Fed cutting and Europe easing fiscally would be rocket fuel for the euro versus the US dollar. At least that’s how our FX strategists see it, and it’s one reason why they are strategically as well as tactically long the euro.
But while the next crisis might be less severe, the limited policy toolkit could mean a slower and more protracted exit. That’s why we think credit would face real fundamental risk in the next downturn, even if the initial impact is nothing like what we saw a decade ago.