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The lessons of the subprime crisis

13 May 2022

History has a tendency to repeat itself due to a multiplicity of mechanisms such as the behavior of central banks which can overtighten monetary policy, households which over leverage, and over- or under-investments in some essential sectors. That, however, opens windows of opportunities for investors to better manage their risks. But one cannot totally rely on past track record or back-tested strategies to implement this, as new mechanisms emerge with zones of instability and future growth is simply not easy to predict.

The subprime crisis

Following the 2001 US recession, tax cuts and easy monetary policy supported growth and demand for Chinese goods reinforced by an artificially weak renminbi. We saw back then the rapid emergence of China and BRICs (Brazil/Russia/India/China) which exported deflation, and a US consumer that went on a house-hunting binge increasing leverage even for those with poor credit metrics. Banks simply sold off these risky mortgages. Eventually, the real estate market came undone and an enormous global credit crunch ensued known as a Minsky moment. Fear of this was typified by a 2007 UBS report from George Magnus “The Credit Cycle and Liquidity: Have We Arrived at a Minsky Moment?”. The question he asks now is whether this is the time of China’s Minsky moment given its very expensive real estate market?

The anything goes rally

The post-2008 period was one characterized by a globally very loose monetary and to some extent fiscal policy with a massive push into infrastructure and real estate in China. Financial assets rose to anticipate the long-term growth, with equity rising much faster than debt decreasing leverage. Inelastic assets such as real estate, Tech and eventually cryptos benefited enormously, especially on a quest for real assets amid fears of currency debasement. In China for example, the vast majority of household wealth is stored in the real estate market. As inflation now shocks the economy, the question is whether the house of cards will fall. As happened in the subprime crisis, different markets send early warning signals. Could it be now Unicorns (Tech holdings high on hope, low on revenue)?

This time it is somewhat different

While China is trying to prevent an enormous credit crunch, it may not succeed – and this will be compounded by its zero covid-19 policy. In contrast, in Europe and the United States, banks are far more tightly regulated than they used to be and central banks are far more attuned to financial stability, enabling them to adjust the value of expensive assets by injecting or withdrawing liquidity. The focus may well be on the very expensive real estate market (US, Europe, China) hurting demand from newly-formed households. Stocks outside of the US are actually starting to become attractively valued even though in the US, we are far from fair value – apart from the Tech sector (many unicorns have plunged sharply in value already for example). Amid the widening dispersion, opportunities are starting to build in company, country and factor selection.

What does it mean?

In a period of ongoing economic and political instability, flexibility remains key as does the focus on less risky companies that are cheap and offer a solid path of earnings. Examples that come to mind are Coca-Cola and Air Liquide.

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