Managers pondering how final chapter — quantitative tightening — will play out and what the future holds
Market participants are hoping — warily — that the global financial crisis' final chapter, under the heading of central bank quantitative tightening, can play out worldwide with minimal drama over the next few years.
At the depths of the crisis in 2008 and early 2009, no one was anticipating a nine-year bull run by equity markets powered by a flood of central bank liquidity, said Deb Clarke, Mercer Investment Consulting's London-based global head of investment research.
The question now is whether there's going to be "a price to pay for that (and, if so,) how negative a period we could see in the next 10 years," she said.
"The full story of the GFC is not only the crisis and its response, but the implications of that response, which may not be fully revealed until the next cycle," said Jeffrey Rosenberg, managing director and chief fixed-income strategist with New York-based BlackRock (BLK) Inc. (BLK)
Most observers say, for now, that another systemic crisis is unlikely, even if there's a general consensus that markets should prove much less generous over the coming decade.
That confidence rests, in part, on the more robust regulatory regime put in place after the crisis.
"Changes in money market regulation and securities lending risk management, along with increased capital requirements in banking institutions, have created a stronger and more resilient financial system than we had in 2007," said Stephen N. Potter, vice chairman, Northern Trust Corp., Chicago, and president, Northern Trust Asset Management, from 2008 to 2017.
That shorter regulatory leash for banks, meanwhile, has opened significant opportunities for institutional investors, including pension funds, to fill the void.
For big swaths of the loan market now, "banks are no longer the lenders; hedge funds are no longer the lenders," said Charles Van Vleet, chief investment officer of Providence, R.I.-based Textron Inc.'s $7 billion defined benefit plan. "Both have term structure mismatches — investing in things for three to five years" with depositors who can take back their money in a matter of months.
Instead, "the lender of choice over the last 10 years has increasingly been people like myself, buying debt in lockup structures" — an evolution that has made the financial system much less vulnerable to those term structure mismatches, Mr. Van Vleet said.
Matter of faith
Even so, the unprecedented nature of the monetary policies put in place to pull the global economy out of an economic tailspin 10 years ago makes that relative optimism about their reversal — to some degree — a matter of faith.
"People can try to tell you they think they know what it will look like, but you can't look at any historical period (for clues on) how economies and asset classes are going to react," said Michael W. Roberge, the CEO of Boston-based MFS Investment Management.
"You'll have to look back in five years and see what it all meant," he said.
"It's the greatest monetary experiment of our lifetime, and we're coming into an environment where central banks will take liquidity out of the system," said George Gatch, the CEO of global funds and institutional at J.P. Morgan Asset Management (JPM), New York.
"They've done it thoughtfully and cautiously, but the end of the story has not been written yet, and I do think that's one of the key risks to the markets," Mr. Gatch said.
"I'm generally optimistic … they'll be able to thread the needle," he added.
Some market veterans contend such hopes will be dashed.
Market intervention by policymakers inevitably sets the stage for market crises and "we are now, since 2008, experiencing the greatest manipulation of our monetary system in history," said Mark Spitznagel, president and chief investment officer of Universa Investments LP, a Miami-based hedge fund focused on risk mitigation strategies.
Mr. Spitznagel rejected claims that lessons learned from the GFC about managing liquidity will allow money managers and asset owners to dodge the next bullet. "Everybody's a momentum investor today, thinking a bell's going to ring (when the music stops) and they'll be able to get out," he said. Instead, "everybody is going to have to bail at the exact same time," which will torpedo the "presumption of liquidity" helping market players sleep at night now, he added.
Mr. Spitznagel said his firm's risk mitigation strategy, offering clients the "non-linear" prospect of a small loss if markets continue to trundle along and a big payoff should markets crash, is seeing an influx of clients this year, with public pension funds among the newest adherents. He declined to name any clients.
Less apocalyptic environment
Most money managers and asset owners expect a less apocalyptic, if still difficult, environment in coming years, while conceding that black swans, like a trade war or a debt crisis in China, could emerge.
This period of monetary tightening in the U.S. and elsewhere is "a potentially significant new chapter," said Thomas E. Faust, CEO and president of Boston-based Eaton Vance (EV) Management (EV). "We could have a hard landing, particularly if there's a trade war (but) absent that, I don't see a reason why that should happen," he said, adding, "I'm hopeful but my eyes are wide open to the possibilities."
Brian McDonnell, the Boston-based head of Cambridge Associates LLC's global pension practice, said his gut tells him 10 years of tepid returns is likelier than a huge GFC-style shock over the coming decade, although even that less violent outcome would have an impact "on asset owners of every stripe."
Michael Brakebill, chief investment officer of the $44 billion Tennessee Consolidated Retirement System, Nashville, said the ripple effects of the policy response to the crisis have been mixed so far.
On the positive side, asset owners have been able to battle back from dramatic underfunded positions at the height of the crisis but longer term, rock-bottom interest rates and the collapse of expected returns is putting "more pressure on us all," he said, adding, "that's why we see place after place dropping expected actuarial figures and that kind of thing."
Even in the tepid return camp, a number of market veterans predict the damage to portfolios as quantitative tightening proceeds could prove worse than many people anticipate.
There's been a bear market in credit for the past six months as the U.S. Federal Reserve has tightened policy and the next 12 months — with the European Central Bank slated to join in — will bear watching to see how much damage results, said Ben Bennett, head of credit strategy with London-based Legal & General Investment Management (Holdings) Ltd.
Volatility could be worse than many expect because "people have gotten so used to free and easy monetary conditions post the financial crisis that … there are plenty of portfolios and investment managers whose positioning is not appropriate for normal monetary conditions," he said.
MFS' Mr. Roberge agreed, saying whenever the next market cycle begins to unfold, the outcome could be more volatile and "ominous" than people believe.
There shouldn't be a systemic crisis but quantitative tightening "can't be costless," Mr. Roberge said. "If it was, why wouldn't central banks grow their balance sheets all the time to infinity," he asked.
Making the outlook more challenging, fixed-income liquidity will be a lot lower than in previous cycles, when banks played a much bigger role in trading, Mr. Roberge said.
Greater price volatility
The big pools of capital stepping in now, including sovereign wealth funds, pension funds and big private markets managers, won't be putting in bids a mere "couple of points" down — a market environment that should lead to much greater price volatility, he said.
"We're not smart enough to know" when that next cycle will begin but MFS has begun preparing for it, upgrading the quality of its holdings, Mr. Roberge said.
Noel O'Neill, head of global investment research with Boston-based investment consultant Cambridge Associates LLC, said when push comes to shove, he sees fair odds of an "ugly" market episode occurring over the next two or three years.
LGIM's Mr. Bennett said the volatility in credit markets over the coming 12 months or so could well lead to a 10% to 20% correction for equity markets, although that development, in turn, would be likely to prompt central banks to start supporting markets again.
He said his pessimistic scenario would be if a pickup in inflation — perhaps due to tight labor markets — would prevent central banks from making that accommodative shift.
Other market veterans expressed concerns that China's economy or geopolitics could emerge as complicating factors.
When the GFC erupted 10 years ago, China's massive injection of liquidity into the market, at more than $500 billion, was a significant boost for the global economy.
Today China is a much bigger part of the global economy and has become much more leveraged, noted Cambridge Associates' Mr. McDonnell. The ability of China's policymakers to balance that country's growth while managing its debt bears watching, he said.
Daniel Ivascyn, chief investment officer with Newport Beach, Calif.-based Pacific Investment Management Co., cited political risk as a potential fly in the ointment when global debt levels have reached record highs and rock-bottom interest rates have unleashed an aggressive search for yield.
With populist candidates at the helm in the U.S. and abroad, relying on the paradigms of yesteryear could prove a poor match in an environment where risks "could change very quickly," he said.
Reporters Christine Williamson, Rick Baert, James Comtois and Rob Kozlowski contributed to this article.