The global financial crisis in 2008 marked a watershed for financial markets. It showed that there was very little understanding of how markets functioned when lots of investors wanted to exit their investment portfolios at the same time.
The lack of liquidity highlighted the importance of segmentation, between different individual assets within a market or indeed between different markets. Systemic risk manifested itself as ‘correlations all converged to one’. Liquidity became an issue because it put downward pressure on asset prices and drove concentration in asset correlations.
There was significant turbulence in the financial markets in the summers of 2011 and 2013, and more recently in December 2015, when the Federal Reserve in the US hiked up interest rates for the first time since 2008, from 0.25% to 0.5%. This came with the indication that the Fed could increase rates a further three times in 2016. Jim O’Sullivan, Chief US Economist at High Frequency Economics, said of the most recent hike: “Equities could go up or down based on history, although my guess is that Fed tightening is at least a bit of a negative for equities.”
Failure to predictThe Fed action was followed by a sudden drop in the value of assets as investors decided to exit their equity investments in unison with global equity markets going into bear market territory in January 2016. Falls of 20% were recorded. The drop was in part attributed to fears of an economic slowdown in China, with its dramatic effect on industrial metals prices and with oil prices declining to 2003 levels, causing a rapid slowdown in investment in US tightly held oil.
So why did this happen? Listening to a string of economists rationalising the situation at the World Economic Forum in January this year, you would think that anyone should have seen it coming. The fact that they did not paints a fairly damning picture of the capability of economists to forecast asset prices and, above all, indicates how little we understand about how markets function. This is particularly disappointing in the light of the history of markets.
Warnings from near historyWe don’t even need to look very far back to see a warning. In the summer of 2013, the then Chairman of the Federal Reserve, Ben Bernanke, started to taper off its quantitative easing (QE) programmes and decided to stop buying bonds. This resulted in a surge in volatility that hit global financial markets. Investors poured money out of the bond market and a so-called ‘taper tantrum’ ensued.
Financial markets acted out. Bond yields surged as investors priced markets for the removal of central bank bond purchases. Further tightening of monetary policy in the US was expected.
The brunt of the tantrum was felt most in emerging markets. It is well appreciated that changes to monetary policy, or even signals of such changes, could affect the world outside the US. The strength of the markets’ reaction was a surprise. This reaction was why, in the aftermath of the taper tantrum, it was considered important to prepare properly for the moment when the Fed would not just talk about raising interest rates, but actually do so.
With this warning from very near history, market participants should have been prepared to absorb the effects of the Fed’s action on asset reallocation. This did not happen.
Misunderstanding causesWhen we look at the Lehman Brothers collapse and the seemingly endless reverberations of this on the global economy, it is very clear that the effects are not a direct result of a massive shock, as if Lehman was some Fukushima-like event that overwhelmed the global financial system’s defences. It is rather that the network effects of interconnected markets amplified the initial shock and created new shocks that the global financial system was unprepared for.
If this is correct, then we need to be far more vigilant when looking for catastrophic events, as the initial event may well not look catastrophic at all. It is not the event itself that we should focus on, but rather the feedback and feed-forward repercussions and the so-called spillover effects of the event within, and across, different financial markets. Something that no individual institution, central bank or otherwise, is well set up to understand.
The original version of this article was published in the March 2016 print edition of the Review.