Financial Crisis 2020 Part 1/2

How secure is your portfolio?

“It wasn’t raining when Noah built the ark”
– Howard Ruff

We are experiencing the longest bull market in recent history, with ten consecutive years of rising stock prices. Since 2008, many members of the millennium generation have entered the world of work, and a significant proportion of them have become investors themselves. We are talking about a whole generation of people who are in the market and have never experienced a downturn. It is therefore very easy to be complacent and to infinitely extrapolate the wonderful performance of the last decade into the future.

But history teaches us that market cycles are cyclical. External circumstances can change. Yet excessive greed and fear remain constants, leading to ups and downs. It is dangerous to make a linear extrapolation of past performance and expect it to continue indefinitely.

We are at a stage where the “top rating” is in sight. What often follows is either a soft (correction) or a hard (crash) landing, but in any case a landing. It is therefore important to take action and actively protect your portfolio, regardless of the results of the next 24 months.

In this article we will discuss:

1._Why do crises occur?

2._Proof that the next one is imminent

3._Which assets are most at risk?

4 _What can you do to reduce the risk?

Note: In this article we will mainly refer to the US and UK markets as they are the main market drivers. The dollar is also the most important international currency.

Why do crises happen?

Recessions have occurred regularly in our economic history for various reasons (e.g. economic mismanagement, wars, disease, human greed). Over the last 120 years, and with the exception of the two world wars, recessions in developed economies have tended to be the by-product of the boom-bust cycle, often fuelled by easy access to capital.

The recent downturn (the Great Recession of 2007/09) was a classic example of the credit-driven cycle:

• After the dotcom bubble, loans became readily available and peaked in 2006, with sub-prime mortgages accounting for 20% of total mortgage lending;
• Asset prices (especially US housing prices, but financial assets in general) became increasingly inflated and often exceeded asset values;
• More investors followed, entering the market in the hope of higher returns (herd mentality); this drove the asset price up further;
• Then subprime borrowers defaulted on their mortgages on a large scale, as the teaser installment expirations and monthly repayments became unaffordable;
• Lenders suddenly had vast amounts of non-performing loans on their books, causing them to do two things:
  • Take massive repossessions of these properties: This led to a sudden increase in the supply of real estate, with no matching demand, and hence a dramatic drop in US house prices;
  • tighten credit criteria across the board: often indiscriminately, depriving companies of capital and stifling growth
• The economic outlook suddenly became less positive than before, causing investors to reassess their investment and start selling their holdings;
• When the sale continued, it became a self-fulfilling prophecy (due to the herd mentality) and led to a collapse of the financial markets.

As a result of the Great Recession, the three main central banks of the world (Federal Reserve, Bank of England, European Central Bank) used two key instruments to stimulate stagnant economic growth:

1._Quantitative easing (QL): The creation of “cash” by central banks to purchase financial assets, raise their price levels and maintain market confidence

2._Reduction of interest rates: This lowered the cost of borrowing to encourage investors to borrow and use it productively

The evidence: Why is the next crisis around the corner?

These two instruments have significantly increased overall liquidity in a previously stagnant market. They were undoubtedly instrumental in the rapid economic recovery that followed. However, both instruments also led to a rapid increase (or recovery) in asset prices across the spectrum because:

• Significant demand pressure from QL
• Negligible borrowing costs (the real interest rate was negative compared to inflation in most industrialised countries), which further fuelled the appetite for asset acquisition and exerted pressure on the demand side

Due to a decade of quantitative easing and low interest rates, most stock market indices in the industrialised countries recorded a rapid increase in valuation. As a result, these assets were at full price: intrinsic value plus market premium.

• The S&P 500 index rose by 260% between January 2009 and January 2019;
• The Central London Property Index rose by over 100% between its low in December 2008 and December 2017;
• The Swiss Private Property Index showed a stable performance between December 2008 and December 2016, rising 40%.

The sustainability of such a valuation depends on two conditions:

• Abundant liquidity in the market (either through QL or low interest rates)
• Continued growth expectations

Recently, however, there have been signs that both factors are diminishing in today’s market and that equity market valuations are becoming increasingly risky.

To be continued in Part 2