- While central banks deserve credit for implementing quantitative easing (QE) programs that arguably saved the global economy, they face an uncertain future as those programs are withdrawn.
- New regulations may have curtailed the riskier activities of investment banks, but could they also dampen economic activity and exacerbate future crises by limiting the availability of liquidity?
- Financial markets have performed well in recent years, but as QE is withdrawn the global economy may face a return of volatility, inflation, and political unrest amid growing inequality.
- In this environment, investors may need to reconsider their strategies as a trickier market environment throws up more idiosyncratic opportunities.
It’s been just over a decade since the sale of stricken investment bank Bear Stearns to JP Morgan Chase provided a clear warning sign that the collapse of the U.S. subprime mortgage market was developing into a much larger financial crisis. Now, 10 years later, the vast amounts of emergency monetary stimulus injected into the global economy during and after the crisis are being withdrawn. But as central banks pursue the long process of unwinding their quantitative easing (QE) programs, the question arises: What kind of investment landscape will investors now face?
We asked six of T. Rowe Price’s senior investment professionals to share their views on the legacy of the global financial crisis (GFC) and how it might continue to influence markets in the years to come. Our questions focused on four main areas: (1) the role of central banks, (2) the effects of financial regulation, (3) the outlook for the global economy, and (4) changes in investor behavior. Their answers point to a challenging period ahead as market participants adjust to a post-stimulus environment marked by declining liquidity,tougher regulations, rising interest rates, and higher volatility—but one that also should offer compelling opportunities for those with the insight and agility to benefit from them.
CENTRAL BANKS RECEIVE A STRONG REPORT CARD, BUT FACE AN UNCERTAIN ROLE
Given the severity of the GFC, the subsequent recovery in global financial markets has been remarkable. In 2008, the financial system was on the verge of disintegration; since then, stock markets have surged (Figure 1), bond yields have declined, property and commodityprices have risen, and expected volatility has—apart from the occasional spike—remained largely muted (Figure 2).
QE has played a major role in this recovery. Unprecedented levels of bond purchases by central banks kept interest rates low, liquidity in plentiful supply, and volatility suppressed—very likely preventing the financial crisis from becoming an economic catastrophe. “I think history will write the central banks avery strong report card,” says Arif Husain, head of International Fixed Income.“ QE has had some costs—savers were not exactly high-fiving each other about negative rates, for example—and you could argue that central banks have been too slow to withdraw stimulus. But overall, you have to say that they did what they needed to do, and it worked very well.”
Having deployed QE with such largesse once, however, central banks may have exhausted it as an option for the foreseeable future, Husain believes. “When it was first implemented, there was the ‘wow’ factor—and markets responded accordingly,” he says. “Butwhen the element of surprise is no longer there, future monetary stimulus may be less marginally effective, which may mean that central banks will have to find new methods to have any impact.”
It may also be politically difficult for central banks to undertake further rounds of monetary stimulus. One reason is the sheer cost: QE has resulted in supersized central bank balance sheets, which are difficult to justify over the long term (Figure 3). Another reason is the fact that while QE has boosted asset prices, its economic impacts are less clear. For most of the decade following the financial crisis, growth remained sluggish in most parts of the world, inequality increased, broad income gains were difficult to find, and central banks repeatedly fell short of their inflation targets. More recently, growth levels have begun to indicate that a more synchronized global recovery is now underway, but skepticism remains about whether QE has significantly benefited economies as well as financial markets—meaning any further rounds would potentially be unpopular with the public.
“There are a lot of people in Congress who don’t like it that the Fed bought USD $4 trillion in government-issued securities, and there are people in Europe who feel the same about the ECB’s [European Central Bank] bond purchase program,” says Alan Levenson, chief U.S. economist. “Sothere could be considerable political pushback against doing QE again.”
The reaction to QE raises an important question about the future role of central banks: Should they continue in their postcrisis guise as powerful, largely independent bodies with the scope to rescue national economies when fiscal policies prove inadequate, or should they return to their traditional role of seeking to manage interest rates and inflation? If it is the former, it may be necessary to formally redefine the role of central banks and their relationship with government in order to improve transparency and accountability. If it is the latter, central banks will need to demonstrate that their primary focus is once again on managing inflation.
If extraordinary QE measures are deemed either too ineffective or too politically difficult to use when the next significant downturn or crisis strikes, central banks may find themselves with limited tools to act—particularly as interest rate cuts, their traditional tool to stimulate demand, will not be a viable option for some time to come as rates are still very low by historical standards. “We’re a long way from the crisis now, and central banks have exhausted the stimulus they can administer,” says Levenson. “So it stands to reason that they are past the peak of their influence for the time being.” In other words, central banks may have fewer levers to pull in the next downturn unless asset price declines threaten to become extremely severe.
PROGRESS ON REGULATORY REFORM
In a 2017 report, the Financial Stability Board delivered this scorecard on financial reform in the G-20 countries:
- Strengthening Financial Institutions: Implementation of Basel III capital and liquidity standards has generally been timely, and banks continue to build higher- and better-quality capital and liquidity buffers. More work is needed to implement other Basel III standards.
- Ending Too-Big-to-Fail: Implementation of higher loss-absorbency, total loss-absorbing capacity, and more intensive supervision is advancing well for global systemically important banks. But progress has been slower on other resolution reforms.
- Making Derivatives Markets Safer: Implementation of these reforms is now well progressed, although it has taken longer than originally intended. Overall, implementation is most advanced in trade reporting, but significant challenges remain for its effective use.
- Transforming Shadow Banking Into Resilient Market-Based Finance: Implementation of reforms on the oversight and regulation of shadow banking entities, including money market funds, securities, financing transactions, and securitization, is progressing but remains at a relatively early stage.
HAS REGULATION MADE THE FINANCIAL SYSTEM MORE RESILIENT?
The post crisis period not only redefined the role of central banks, it fundamentally changed the way that commercial banks operate. A raft of regulatory measures has been enacted in recent years to improve the resilience of the global financial system, driven by major legislation such as the Dodd-Frank Act in the U.S. and the European Market Infrastructure Regulation in the EU. The international Financial Stability Board has divided these measures into four key areas. In its 2017 annual report on regulatory reform in the G-20 countries,1 the Board said that advances had been made in all of them—although it also stated that overall progress had been “uneven” and that more work needs to be done (see “Progress on Regulatory Reform”).
Rob Sharps, head of Investments, says that many of the rule changes introduced since the crisis have been crude but effective. “Regulation is a blunt instrument, but the GFC was so extreme that it required an extreme regulatory response,”he says. Sharps cites measures that limit the use of leverage by financial institutions. “Banks are now required to hold a greater quantity of better-quality and more liquid capital than before, which will restrict their activities,” he says. “But I think the new rules will mean that the system as a whole is better-placed to prevent contagion in the event of a future crisis.”
Other measures, such as ring-fencing investment banking away from retail banking and imposing tighter lending criteria, are also likely to have an impact. But while these initiatives will reduce the risks that financial institutions can take, they could also dampen economic activity by preventing individuals and businesses from borrowing money when they need it.
So far, this has not caused major problems as the economic impact of the new rules has been largely offset by the amount of central bank liquidity in the system. Indeed, Gabe Solomon, portfolio manager of T. Rowe Price’s financial services strategy, says the tougher regulations introduced since the GFC may have even helped prolong the post-crisis bull market. “I think restrictions on the financing available to individuals and companies have significantly extended the business cycle since 2008,” Solomon says. “It’s difficult for small businesses to get loans, which has limited the risk they are able to take. Without this effect, we would probably have had a much more dramatic—but perhaps shorter-lived—expansion over the past few years.”
The curbs on banking activities are likely to be more keenly felt in the future, however. With investment banks no longer able to provide market liquidity to the extent they have done in the past and central banks potentially challenged to materially expand QE, the onus will be on other market participants to bridge the funding gap. If they do not do so, the resulting lack of liquidity could make any future crisis worse, undermining efforts to safeguard the system by restricting bank activity. “In the past, banks would deploy capital wherever they believed assets were undervalued and they therefore could sell them back to the market fora profit at a later date,” says Quentin Fitzsimmons, a senior portfolio manager in the Fixed Income Division. “This provided a lot of liquidity. But in the future, that buffer will be considerably thinner.”
It is also important to note that while the regulations put in place over the past few years may prevent a repeat of the last crisis, they may provide only limited protection against a future crisis if the causes are different—which they almost certainly will be. “The next significant financial crisis will likely be caused by something that most people are not concerned about today,” says Solomon. “Future asset bubbles will invariably arise. It is simply the unavoidable cyclical nature of financial markets.”
The lesson? Regulations are never a substitute for vigilance and risk awareness from institutions and investors.
A RECOVERING GLOBAL ECONOMY FACES INFLATION, VOLATILITY, AND INEQUALITY
The financial and regulatory changes putin place since the GFC make it difficult to chart a clear course for the global economy over the next few years. If QE was unprecedented, so may be the process of adjusting to its withdrawal. As things nowstand, yields continue to hover near record-low levels in most bond markets, equity markets remain robust, unemployment is falling in many countries, and global growth is improving. At the same time, however, there are concerns that many financial assets are overvalued, corporate leverage is too high, and inflation—followed by rate hikes—may be lurking in the wings.
Fear of rapidly rising inflation, in particular, remains a concern for many investors.
1Implementation and Effects of the G-20 Financial Regulatory Reforms, 3rd Annual Report, July 2017.
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