The financial landscape looks very different today than it did in 2008, when the collapse of Lehman Brothers almost brought down the entire financial system.
In the post-crisis period, a raft of regulatory measures were introduced to improve the resilience of the financial system and these fundamentally changed the way commercial banks operate.
Banks are now required to hold a greater quantity of better-quality and more liquid capital, which restricts their activities and the ability to hold risk assets on their balance sheet. This has driven disintermediation away from banks to non-banks, which are now holding much more risk than they did before. This is a concern.
The curbs mean banks are no longer able to provide as much market liquidity to the extent they did before the Lehman collapse. For several years, this was not really a major problem, because central banks were flooding the markets with quantitative easing (QE). But that support is now being withdrawn, and the onus is on other market participants to bridge the funding gap.
So far, they are doing so, but it is uncertain whether there will be sufficient liquidity in the event of another crisis. Banks would usually deploy capital at such times, but as banks can no longer act as the liquidity buffer, the markets may find themselves on their own when trouble hits.
The role of central banks
QE played a major role in the post-Lehman recovery as central banks redefined their role as powerful, largely independent bodies with the scope to rescue national economies. For well over a decade, unprecedented levels of bond purchases by central banks kept interest rates low, liquidity in plentiful supply, and volatility suppressed.
But as structural shocks left by the coronavirus pandemic and Russia’s invasion of Ukraine caused inflation to rise to multi-decade highs, central banks have refocused their attention on managing inflation.
For central banks, the past 20 months have been in stark contrast to the decade that preceded them. Most notably they have hiked interest rates, which now appear close to their peak.
Central banks have also moved from being the buyers of last resort in financial markets to being active sellers as they commenced quantitative tightening to reduce their supersized balance sheets.
The implications for markets have been profound. Investors now face a very different landscape of tighter liquidity, more volatility, and higher interest rates. The inverse correlation of stocks and bonds has also broken down and while it may return if there is a recession it is unlikely to be as stable as during the post-financial crisis era because central banks are no longer supporting markets.
An era of deglobalisation
Another important post-Lehman change is deglobalisation. We are firmly past the peak of market liberalisation, with clear long-term deglobalisation trends now in place. Russia’s invasion of Ukraine and the coronavirus pandemic have prompted many countries to look inward and re-localise economies.
This is inflationary, as is the unprecedented level of public and private spending likely required to decarbonise economies, which is expected to accelerate in the coming years.
Some of this may be offset by technological changes that prove to be deflationary. Generative artificial intelligence, for example, is a key technological step forward that should enable goods and services to be scaled more efficiently, driving down prices.
Overall, however, inflation will probably settle at higher-trend levels in the long term, which means central banks may find themselves under some political pressure to loosen targets in the future.
Some 15 years on from the Lehman collapse, market dynamics have changed considerably and continue to evolve. The period ahead will be challenging for investors as they adjust to a post-stimulus environment marked by tighter liquidity, higher interest rates, and more volatility.
However, it will also likely be one that offers compelling opportunities for those with the insight and agility to benefit. Flexibility and an active approach are likely to be key.
Quentin Fitzsimmons is co-portfolio manager of T. Rowe Price’s Dynamic Global Bond strategy. The views expressed above should not be taken as investment advice.