Getting Started in Shares For Dummies Australia. Dunn James
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to sub-prime mortgages at all.
The low-interest-rates policy of the Federal Reserve had also allowed institutional investors to borrow heavily, and invest in mortgage-backed securities. Much of the mortgage-backed derivatives house of cards was kept off the banks’ balance sheets, in a variety of investment vehicles. But the banks were forced to bring their exposures back on to the balance sheets, even though they had not set aside enough capital to back them. This resulted in massive write-downs, a river of red ink flowing through the books of some of the biggest names in global finance.
By June 2007, Wall Street investment bank Bear Stearns was in financial difficulty, having leveraged its balance sheet 35 to 1: For every dollar of equity, Bear Stearns had $35 of borrowings. Because many of the assets (securities) that had been bought with this borrowing were now worthless, both lenders and investors lost confidence in Bear Stearns. In March 2008 it was sold to JP Morgan Chase in a bail-out organised by the Federal Reserve.
The financial industry was in disarray: No one knew which bank was holding which liability, and who was a counterparty of whom. The availability of credit virtually ceased. If portfolios such as those held by Bear Stearns were to be liquidated, no one knew which other banks or investors could collapse. Confidence evaporated.
The GFC peaked following the collapse of Wall Street investment bank Lehman Brothers and the bail-out of global insurance giant AIG by the US Federal Reserve in September 2008. The following six months saw unprecedented stress in global capital markets. By now investors were questioning the very solvency of banks, and global stock markets were slumping. By this stage short-sellers were attacking stocks like sharks around a sinking cruise ship, magnifying the share price falls.
What no one could have foreseen was how what had essentially been a financial industry problem affected the real economy when Lehman Brothers collapsed. Bank-lending to businesses, the life blood of the economy, shut down; banks were unwilling to lend to each other, let alone businesses. Letters of credit – which finance 90 per cent of global trade – were starting to be dishonoured.
Because businesses could not get letters of credit, world trade ground to a halt. The Baltic Dry Index (a proxy for the cost of world shipping, and thus an indicator of world trade) fell 85 per cent between May and October in 2008. With goods unable to leave the docks, factories cut their activity and industrial production slumped. By late 2008/early 2009, the fear was no longer whether the world had a functioning financial system, it was whether the global economy still functioned.
In the first quarter of 2009, at annualised rates, the US economy shrank by 6.1 per cent, while Japan’s economy contracted by 15.2 per cent, Germany’s by 14.4 per cent, the UK’s by 7.4 per cent and the Eurozone by 9.8 per cent. With demand slumping, world trade fell by 12 per cent in 2009, according to the World Trade Organization (WTO).
By 2010 the focus of the GFC had spread to the debt held by governments. The European sovereign (government) debt crisis mainly hit the so-called PIIGS countries – Portugal, Ireland, Italy, Greece and Spain – which typically run huge budget deficits. In 2010, Greece and Ireland had to be bailed out by the European Union (EU) and the International Monetary Fund (IMF). In July 2011 even the US (considered to be the world’s best credit risk), went close to technically defaulting on its debt.
Slowly the banking system has repaired its balance sheets, after US$2.8 trillion worth of write-downs (slashed asset values). In 2008 the Federal Reserve began pumping trillions of dollars into the US financial system through its quantitative easing policy, by which it increased the quantity of available money by buying assets such as government bonds and mortgage-backed securities, and creating new money to pay for them. In this way, the Federal Reserve pumped about $US3.7 trillion into the global financial market.
The European Central Bank and the Bank of Japan conducted similar programs – with the Japanese mounting a quantitative easing programme even larger than that of the US, relative to the size of the economy.
Post-GFC, the major issues for the world economy – and thus, the sharemarkets – have been continued economic weakness in Europe, Japan and North America; a slow-down from the locomotive of world economic growth, China; and an amassed mountain of debt. The McKinsey Global Institute calculates that global debt has increased by nearly 20 per cent since 2007, growing by US$57 trillion.
Initially, China’s economic growth provided support to the world economy: China grew its economy by 10.3 per cent in 2009. But China’s growth rate has slowed as the country transitions to what Beijing considers more sustainable growth – that is, growth generated more by domestic consumption than growth driven by massive infrastructure investment. This well-advertised process saw China’s official 2015 second-quarter annual growth rate come in at 7 per cent, the slowest pace since the GFC in 2009, and the World Bank expects the growth rate to start with a 6 by 2017.
Economic growth in the Eurozone has struggled, with the bloc slipping back into recession in 2012 – for the second time since the GFC – and narrowly avoiding a ‘triple-dip’ recession in 2014 with the escalating crisis in Greece. In mid-2015, Greece became the first developed country to default on a payment to the IMF, and investment markets were once again plunged into turmoil by the possibility of Greece leaving the eurozone, with unknown ramifications for the single European currency.
With many major European economies forced to use public funds to bail out banks, the debt/GDP ratio in European economies boomed. As holders of European debt became increasingly nervous about the ability of the PIIGS to meet their debt obligations, bond premiums spiked, and the risk of European economies being unable to meet their debt repayment schedule led to a secondary, highly damaging European economic crisis from 2011 to 2013. In June 2015 the Greek electorate voted to reject the terms of an extended EU bailout (effectively a second bailout), causing stock markets around the world to tumble. In July 2015 Eurozone leaders reached a deal on a third bailout package, which started to flow in August 2015. But Greece’s problems are definitely not solved – there are still concerns about its bailout and arguments with its creditors raging at the moment – but it seems the markets moved on to worry about other, bigger things (like China).
In 2012, a new Japanese government tried economic shock therapy in the form of an all-out assault to jolt the long-moribund Japanese economy out of recession, based on creating massive fiscal and monetary stimulus, making company tax cuts and weakening the yen to increase the competitiveness of Japan’s exporters. There was some initial success for the ‘Abenomics’ program – named after Prime Minister Shinz Abe – but by mid-2015, Japan was back to its familiar state of zero growth.
In the US, the years 2008 to 2012 were the worst four consecutive growth years since the 1930s. The US economy had been trying to mount a recovery, with GDP growth reaching 2.4 per cent in 2014, but America’s economy was reported to have shrunk in the first quarter of 2015 – the first contraction since the second quarter of 2009. The Congressional Budget Office now says the US economy grew by 2 per cent in 2015, however it projects stronger growth (2.7 per cent) in 2016 before dropping again (2.5 per cent) in 2017. The US has now held interest rates near zero for nearly a decade, and in mid-2015 the IMF, for the first time, urged the Federal Reserve to hold off raising rates to avoid potentially stalling the US economy and wreaking havoc in global markets.
The IMF expected global economic growth to slow in 2015 to its weakest rate since the GFC, as China and other emerging markets decelerate and advanced economies continue to struggle to shrug off the legacies of the crisis. The final IMF figure for world economic growth in 2015 came in at 3.1 per cent, the weakest since the global economy contracted in 2009. More positively, however, the IMF expects global growth to rise to 3.5 per cent in 2017.
The GFC was the greatest crash of them all, but slowly, painfully, sharemarkets began to recover:
