The Lessons of 2008 Have Left Europe's Markets Better Protected

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The Lessons of 2008 Have Left Europe’s Markets Better Protected

By William Shaw and Jan-Patrick Barnert

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(Bloomberg) —

The convulsions in European markets for the past month have traders looking back to 2008-2009, the last time the financial world seemed on the verge of collapse. The good news this time around is that policy makers are applying lessons learned from that crisis.

From the U.S.’s $2 trillion rescue package to massive bond buying by the European Central Bank, officials have moved quickly to cushion the impact of the coronavirus outbreak. Sure, the responses have been uneven from country to country, the European Union’s members have struggled to agree on the details and the more ambitious ideas, like sharing the debt burden, seem out of reach for now. But overall, investors have been reassured by what they’ve seen.

“A key lesson from the 2008 crisis was for central banks to act quickly and be bold,” said Jordan Rochester, a foreign-exchange strategist at Nomura International Plc in London. “They’ve done both in this crisis.”

To put the response in perspective, in 2008 several months elapsed between action by the Federal Reserve and the launch of a rescue program for troubled assets. And in the subsequent euro-area debt crisis, investors criticized policy makers for repeatedly kicking the can down the road on matters such as how to rescue Greece.

Of course, the great crisis of more than a decade ago was a financial event rooted in the real estate market that had economic consequences; both the cause and the effect could be addressed by regulation and fiscal and monetary policy. This time around, all the stimulus in the world won’t help if the underlying public health catastrophe isn’t brought under control. Indeed, stocks finished the week with a decline Friday, ending three days of gains, as case numbers in the U.S. and elsewhere mounted.

That said, here’s a look at how markets have responded to the stimulus efforts, and how they’ve been informed by the 2008-2009 experience and the debt crisis.

Stocks

Equity markets falling about 40% looks pretty similar to previous shocks; the speed of the fall is the main difference. The good news is that the massive risk-off event has also sparked a faster response from central banks and more importantly governments, which could avoid a structural bear market, according to Goldman Sachs Group Inc. In Germany, for example, the government on Monday announced a 750-billion-euro ($824 billion) stimulus plan at a time when the benchmark Dax Index was down 38% from its peak a month earlier.

“Policy has been fast to adjust this time, and we see this as a large positive and likely to prevent this from becoming systemic,” analysts at the investment bank wrote in a note.

The Stoxx Europe 600 Index reached its pre-2008 crisis peak in June 2007 and didn’t surpass that level until March 2015, almost eight years later. Bank of America Corp. strategists on Friday said the index could gain 25% by the end of August, which would still leave it about 8% shy of its February record. Goldman said stocks have a “good chance” of making new lows in the weeks and months ahead.

Governments are able to build their current measures on institutions implemented during the great recession or the debt crisis, like the European Stability Mechanism, which provides loans to EU member states. That avoids lengthly parliamentary processes and hence spares equities at least some uncertainty. And politics is temporarily turning a blind eye to the rules governing state aid to implement extensive state-guarantee mechanisms for bank loans.

“These mechanisms are crucial if banks are to continue to extend financing to companies in difficulty,” Natixis analysts wrote. The fear and uncertainty about a systemic credit crunch was one of the main reasons for the prolonged equity weakness 12 years ago.

With all the measures in place and central banks watching closely over subdued interest rates, there is a chance for deep but short-lived pain, enabling a faster equity market recovery.

“The recession is poised to be extraordinarily severe but relatively short, bottoming out in 2Q or early 3Q 2020,” said Francois-Xavier Chauchat, member of the investment committee at Dorval Asset Management.

Currencies

After weathering some of the worst turbulence since the financial crisis, global currency markets are showing signs of cooling off. A gauge of volatility dipped after governments and central banks unleashed unprecedented waves of stimulus. More are likely to follow and that could calm the market further.

“We still have to get through the dark days that may lie ahead, but that does provide some backstop to market functioning in the short term,” said Ned Rumpeltin, European head of currency strategy at Toronto-Dominion Bank.

Unlike 2008, the current crisis is not of solvency but liquidity, which governments and central banks are trying to prevent from turning into something more catastrophic. That could also draw volatility down further.

The pound and euro both plummeted on the coronavirus, then began to edge up as governments and central banks took unprecedented action to protect the economy. Back in the first half of 2009 the two currencies began advancing as the crisis eased, though strategists are wary of drawing too many lessons from the past.

The pound just finished its best week since 2009 against the dollar, rebounding from its lowest level in 35 years. It could face further out-sized drops if Britain’s lockdown drags on longer than expected or the National Health Service is thrown into crisis.

U.S. dollar liquidity swap line arrangements, introduced gradually during the financial crisis, have played a key role in helping stabilize currency markets this time around, said Nomura’s Rochester. The Federal Reserve, along with central banks in Europe, Japan, the U.K., Canada and Switzerland, announced a coordinated action March 20 to beef up the arrangements in another move designed to keep dollar liquidity ample around the world.

“Going forward, though, we are likely to have a drip feed of bad news via defaults, credit downgrades, layoffs and unknown financial leverage risks popping up,” Rochester said. “Despite the actions of policy makers, there is only so much they can do.”

Bonds

European government bonds have fallen harder than they did during the financial crisis but there are hopes they could stage a recovery. They plummeted around 6% after a misstep by ECB President Christine Lagarde when she said March 12 that the bank’s job was not to narrow spreads on sovereign bonds. The gap between Italian yields and their German peers, seen as a barometer of risk, climbed to the most since June on the comment. Bonds then advanced when the central bank unleashed further buying of the securities.

“The difference between today and 2008 is that yields and central bank policy rates were much higher,” said Peter Chatwell, the head of multi-asset strategy at Mizuho International. He predicts European bonds will generate a positive total return over the coming year and push on to new highs. “But the new normal will be a less steep trajectory, as income and capital gain will be more modest than in the previous decade,” he said.

Credit

European corporate credit default swaps took almost two years to reverse losses in the last two stress tests they faced: the global financial crisis and the euro-area debt crisis. It was January 2010 when the cost of protection against high-grade defaults returned to around 65 basis points, the level prevailing in May 2008, the start of a sharp rise toward crisis highs of more than 200 basis points.

Investors and policy makers have learned the critical need to keep open the primary market for covered, corporate and financial bonds, after it closed for an extended time during the financial crisis. Preserving the market enables funding for companies and banks, which can keep lending to home buyers and businesses, said Jens Peter Sorensen, chief analyst at Danske Bank A/S.

“If you do not have a stable source of funding for the housing market then your economy suffers significantly–just look at the U.S.,” he said. “This hinders the economic recovery.”

©2020 Bloomberg L.P.

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