The financial crisis brought the global economy to the brink, with many regarding the bankruptcy of investment bank Lehman Brothers in September 2008 as the seminal moment of the great recession. That same year, the U.S. housing market went under water, J.P. Morgan acquired Bear Stearns in record time as it too faced collapse, stock markets crashed and the Federal Reserve slashed interest rates to their lowest in history. Ten years on, the J.P. Morgan Research team explores what has changed and what the future could hold for the global economy and markets.
1. What's changed?
Ten years ago, it wasn’t clear to investors that the worst economic downturn since the Great Depression was on the horizon. Four major long-term forces of globalization, deregulation, innovation and falling volatility had built up since the mid-1980s, ultimately creating a vulnerable system that was hard to detect. So how have things progressed since 2008?
Global debt has ballooned
Global sovereign debt has ballooned by 26 percentage points of GDP since 2007. The bulk of the rise is found in developed markets (DM) where debt-to-GDP has surged roughly 41 percentage points—compared to a 12 percentage point rise in emerging markets. With fiscal deficits still relatively elevated, there is no sign that debt levels will be declining in the foreseeable future. The fiscal lending position of DM as a share of GDP fell sharply by more than 8 percentage points to a post-World War II low of nearly -9% in 2009. Despite a substantial decline from its 7.3% peak in 2009, the global fiscal deficit remains elevated at 2.9% of GDP. In the U.S., the fiscal deficit is projected to reach 5.4% of GDP by the end of 2019.
Joseph Lupton, Senior Global Economist, J.P. Morgan
Global sovereign debt has spiked
Global sovereign debt has spiked
The housing bubble
In the years leading up to the crisis, the Fed substantially tightened monetary policy, hiking rates by 425 basis points between 2004-2006. At the same time, mortgage credit growth increased by nearly 45% on U.S. household balance sheets. The securitized products market was booming, particularly non-agency residential mortgages. Issuance rose from $125 billion in 2000 to over $1 trillion per annum in 2005-06. Particular lenders focused on weaker borrowers (subprime and alt-A) and were met with strong investor demand. Government sponsored enterprises Fannie Mae and Freddie Mac bought large volumes of these mortgages from banks and resold them as mortgage-backed securities to investors. This, along with excessive leverage, inadequate lending standards and poor risk controls ultimately led to a collapse of the housing market, the bailout of Fannie Mae and Freddie Mac and the financial crisis of 2008. Today, U.S. consumers are not nearly as exposed to rates as they used to be, with just about 15% of the outstanding mortgage market at an adjustable rate.
Matthew Jozoff, Securitized Products Research, J.P. Morgan
Annual issuance of selected non-agency securities, $ billion
Annual issuance of selected non-agency securities, $ billion
Central bank balance sheets
Over the past decade, major central banks have bought trillions of dollars of bonds to nurse economies back to health. During quantitative easing (QE) the Federal Reserve (Fed) acquired Treasury securities and mortgage-backed securities, with its balance sheet hitting $4.5 trillion at one point. Last year, the Fed started letting some of its bond holdings mature to shrink its portfolio and is currently doing so to the tune of around $40 billion per month. J.P. Morgan Research expects the shrinking of the Fed’s balance sheet to be completed by 2021, with a move down to $3 trillion, but U.S. Treasury holdings will eventually rise above current levels to become the primary asset of their sustained large balance sheet. Outside of the U.S., the European Central Bank balance sheet will start shrinking in 2019, but the Bank of Japan’s balance sheet expansion will likely continue for a while longer.
Jay Barry, Fixed Income Strategy, J.P. Morgan
Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal.
Jamie Dimon
Chairman & CEO, JPMorgan Chase & Co.
Household debt to income
Banks and sovereigns were not the only ones that loaded up on debt in the run up to the crisis; households did too - largely in the form of mortgages. In 2007, U.S. household debt peaked at 1.3 times their personal income, before collapsing during the Great Recession. In dollar terms, U.S. household debt is still climbing. But when factors such as inflation, population growth and income are taken into consideration, the picture looks very different, with the household debt-to-income ratio now 30% lower than its 2007 peak. Debt growth is slower and mortgage delinquencies are at all-time lows too. By contrast, corporations have seen their debt-to-EBITDA ratios increase steadily since the crisis, as issuers have taken advantage of lower interest rates to issue debt.
Matthew Jozoff, Securitized Products Research, J.P. Morgan
Household leverage has declined since the crisis, while corporate leverage is up
Debt-to-income for households vs. net debt-to-EBITDA for corporates
Household leverage has declined since the crisis, while corporate leverage is up
Tougher regulation
In the aftermath of the crisis, international standard-setters introduced bank regulatory frameworks that took a systemic approach to risk. Banks became subject to higher risk-based capital, leverage capital, and liquidity requirements, and tools for resolution were created to protect taxpayers. New institutions were also established beyond the Basel Committee with the creation of the Financial Stability Board. Global regulatory and supervisory frameworks were introduced, such as Dodd Frank and the Comprehensive Capital Analysis and Review (CCAR) to regulate and supervise large banks. In the U.S. and Europe, stress testing requirements were also rolled out. Nearly 10 years on, the Trump administration and Republican lawmakers are now looking to make many post-crisis rules and regulations less onerous, particularly for small and medium-sized banks.
Alex Roever, U.S. Rates Strategy, J.P. Morgan
Poorly conceived and uncoordinated regulations have damaged our economy, inhibiting growth and jobs. It is appropriate to open up the rulebook in the light of day and rework the rules and regulations that don’t work well.
Jamie Dimon
Chairman & CEO, JPMorgan Chase & Co.
A blow to growth
Since 2008, a substantial amount of healing has taken place, but some legacy costs of the crisis remain. A key concern is the sharp deterioration in long-run growth potential and depressed productivity growth. J.P. Morgan analysis suggests that global potential growth has dropped to 2.7% over the past decade, a decline of 0.3 percentage points from its pace a decade earlier. This decline underestimates the actual damage, as regional drops are far greater. Potential growth in EM, for example, has dropped 1.6 percentage points in the last decade. Global annual productivity growth has also fallen by roughly 1 percentage point since 2012.
Bruce Kasman, Global Head of Economic Research, J.P. Morgan
Global growth potential has dropped
Global growth potential has dropped
2. Looking ahead
Global banks have faced an unprecedented level of regulatory scrutiny in the aftermath of the crisis and have never been better positioned from a solvency and liquidity perspective going into the next potential recession. “While the ability to foresee the exact sequence of events that could trigger another recession is limited, banks are unlikely to be the Achilles’ heel the next time around.”
Kian Abouhossein, Head of European Banks Research, J.P. Morgan
We will enter the next crisis with a banking system that is stronger than it has ever been. The trigger to the next crisis will not be the same as the trigger to the last one—but there will be another crisis.
Jamie Dimon
Chairman & CEO, JPMorgan Chase & Co.
U.S. stocks keep climbing
The S&P 500 peaked at an all-time high in late 2007, before collapsing to hit its financial crisis low in March 2009, sinking to close at 677—a fall of over 50% from its peak, making it the worst recession fall since World War II. Since then, U.S. equity-market investors have seen huge gains, with stocks hitting fresh all-time highs in 2018, boosted by strong corporate earnings.
Dubravko Lakos-Bujas, Head of U.S. Equity Strategy and Global Quantitative Research, J.P. Morgan
How much higher can the S&P 500 climb this year?
J.P. Morgan Equity Strategy’s end-2018 target is 3,000. Earnings momentum might justify an even higher S&P target, but trade conflict remains an obstacle.
The rise of passives
Investors are steadily moving into funds that passively track an index instead of being actively managed by a portfolio manager around this index. In equities alone, some $3.5 trillion of mutual funds are managed on a passive basis globally. In addition, end-investors are steadily moving into exchange traded fund (ETFs), most of which are passive, and which have the added advantage of liquidity. Investors like passive funds as they charge lower fees, create less turnover, and in a number of areas produce better after-fee returns than actively managed funds. However, this shift from active to passive, and specifically the decline in active value investors, reduces the ability of the market to prevent and recover from large drawdowns.
Marko Kolanovic, Global Head of Quantitative and Derivatives Strategy, J.P. Morgan
Total ETF assets hit $5 trillion globally, up from $0.8 trillion in 2008. Indexed funds now account for 35-45% of equity AUM globally.*
*As of May 2018
Fixed income liquidity and market depth
While the global bond market has more than doubled to $57 trillion since 2007, liquidity has deteriorated across fixed income markets as banks are playing a lesser role as market makers. Market developments that have taken place since 2008 have led to this severe disruption to liquidity, which could be a key attribute of the next crisis. While gross high-grade bond supply has increased by 50% for the past decade, turnover in the U.S. investment grade corporate bond market is 42% lower and dealer positions for investment grade bonds have fallen by some 75%. This decline in market liquidity alongside the rise in passive investment reduces the ability to prevent large drawdowns in the event of increased market volatility.
Joyce Chang, Global Head of Research, J.P. Morgan
U.S. Treasury market liquidity remains roughly two-thirds below pre-crisis levels.
The perfect hedge?
Ten-year Treasury yields declined nearly 300 basis points during the last recession and the U.S. Government Bond Index returned 14.3% in 2008, the third-strongest annual performance in history. Overall, heading into the next recession, the Fed will have less room to lower policy rates compared to previous recessions. But if form holds, Treasury yields, particularly on shorter-dated maturities, will decline as the market anticipates the onset of an easing cycle. J.P. Morgan Research expects 10-year Treasury yields to fall by half around the next recession, from a peak of 3.5%.
Jay Barry, U.S. Fixed Income Strategy, J.P. Morgan
We expect 10-year Treasury yields to fall by half around the next recession, from a likely peak of 3.5%.
3. Lessons learned
Ten years ago, the financial system was fully exposed. Governments around the world invested taxpayers’ money to save banks from failure, central banks were forced to use unconventional monetary policy to prop up markets and regulators stepped in to try and ensure that a liquidity crisis of that scale could not take place again. Capital and leverage ratios for banks are now significantly stronger and the so-called “too big to fail” global banks have never been better positioned from a solvency and liquidity point of view going into the next potential recession. Banks are also less complex and face harsh stress tests annually to check their ability to withstand severe losses.
Non-bank lenders make up over 80% of mortgage markets
Non-bank lenders make up over 80% of mortgage markets
Compared to 2008, the U.S. consumer is also in much better shape. The household debt-to-income ratio is down, lending standards are vastly improved and households are not as exposed to rate hikes as they once were. Looking at what could trigger another crisis, most analysts agree that the weaknesses that caused the Great Recession will not be the cause of the next crisis, but other risks have emerged in their place. The rotation from active to passive investment reduces the ability of the market to prevent large drawdowns. The structure of the lending landscape has also transformed, with the share of non-bank U.S. mortgage lending surging to over 80% of the market, from under 20% before the crisis, raising questions about stability. Non-bank lenders are typically less capitalized than banks and there is no mechanism to determine who could take over the servicing role of non-banks if they were to go out of business. And for markets, tail risks are also likely to increase in 2019 as the impact of unprecedented monetary policy retreats.
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