• Patrick Ling

Are We Seeing A Repeat Of 2008?

Several market watchers have pointed out how the current crisis is similar to the Great Financial Crisis in 2008. This is because the S&P 500 recent price movement from the start of this year is very similar to the GFC period so far.


S&P 500 price comparison
S&P 500 price movement since the crisis began

Even the 1-month realized volatility of the S&P 500 is eerily similar to the GFC period.


S&P 500 volatility comparison
S&P 500 volatility movement since the crisis began

But the similarities stop there. The underlying cause of the current crisis is very different from the cause of the GFC.


What Caused The 2008 GFC?


The root cause of the GFC was irresponsible lending practices that started years before the crisis. Many predatory lenders were extending loans to people without proper verification that they could service the loans. The investment banks facilitated this practice by packaging these loans into complex mortgage-backed securities and selling them on to investors. The reason why people were willing to buy them was that rating agencies were willing to give them good credit ratings on the premise that diversifying across many loans made them safer. When mortgage rates started to rise, many of the borrowers became either unable or unwilling to service their mortgages. One by one, they started to default and of course, the mortgage-back securities got hit.


How reversible was the problem?


By the time the crisis started, many of the funky derivative products based on mortgages had either been sold to unsuspecting retail investors or were still sitting in the inventories of banks waiting to be sold. If you include the third-party guarantors of such products, the chain had become incredibly convoluted and impossible to track.


All this would not be a problem if miraculously, all homebuyers suddenly have a marked improvement in their financial situation and are now able to service their mortgages. That is not possible and so we can say for sure that the problem was irreversible.


Hence, anyone who had been following the situation closely could safely put on a short bet because the situation was unlikely to resolve so easily. In the end, the government had to bail out the bad actors and took all the bad assets onto their balance sheet. But even that process had to go through hoops before it was possible. Of course, this opened up the new world of quantitative easing that we are so familiar with now.


What Caused The Current Crisis?


There is a link between today's crisis with the GFC. After years of quantitative easing and low-interest rates, the market has gotten used to loose monetary conditions. Amazingly, this did not lead to hyperinflation as some suggested repeatedly in the past. The market seemed to have gotten the best of both worlds, cheap money with low inflation.


All this changed when Covid-19 struck. In an over-zealous drive to shore up the economy, governments around the world boosted their QE program and also threw out large fiscal packages to companies and individuals. Such drastic monetary and fiscal measures were extended time and again as Covid dragged on.


On the one hand, we have a huge liquidity injection but on the other hand, people have nowhere to spend since most shops were closed and people had to stay home. When governments around the world started to relax their Covid restrictions one by one, the pent-up demand was suddenly released. However, the supply chain was still constrained by the world's largest manufacturing country in lockdown. This demand-supply imbalance led to inflation finally rearing its ugly head. The situation was made worse by the Russia-Ukraine war.


How reversible is the problem?


Unlike the subprime crisis in 2008, the current situation can perhaps be classified as man-made. It is a matter of bad management of the liquidity tap due to an over-zealous response to Covid. It is also due to a perfect confluence of events happening at the same time, contributing to inflation.


Inflation is bad but it is the central bankers' effort to tame inflation that is inflicting pain on markets. This is seen when global equity markets were rising nicely during the summer only to be whacked down when Jerome Powell became an ultimate hawk at Jackson Hole. How markets perform is directly related to the amount of liquidity in markets. And with Jerome turning off the liquidity tap, markets have nowhere to go but south.


But if Jerome can turn off the tap, he can also reopen the tap anytime. This is exactly what happened when the Bank of England made a U-turn and restart QE as we have written earlier. Hence, it is a more risky proposition to short the markets today as compared to GFC because we are really at the mercy of what central bankers do.


There are tentative signs of inflation abating, at least in the US. The CRB Index which is a broad measure of commodity prices is coming down.


CRB Index
CRB Index trending down

The 5-year breakeven rate which is the market's expectation of the average annual CPI over the next five years is also within earshot of the Fed's 2% target.


5-year breakeven rate
5-year breakeven rate is nearing Fed's target

Despite the above, the market is still pricing in a better than even odd of a 75bp rate hike in the next FOMC meeting in November.


Market's expectation for rate hike in November
Market's expectation for rate hike in November

This is indicative of a cautious market that has been conditioned by a hawkish Fed. This is good because it reduces the chance of the market being surprised by the Fed.


Conclusion


The similarities between the S&P 500 during this current crisis and the 2008 GFC period are uncanny indeed. However, based on the differences in the underlying causes of the two crises, I would hesitate to expect the S&P 500 to see another repeat of 2008. Unless there is a systematic crisis brewing which I am unaware of.

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