If you work in financial markets, you could be forgiven for thinking there’s a curse on the third and fourth quarters of years ending in a seven, says Erik Knutzen. Standouts are 1987, 1997 and 2007. What about 2017, with the possibility of a nuclear war?
Knutzen, the CIO of multi-asset class for global manager Neuberger Berman, says in a client note ‘Lessons From the Past‘ that in response to US and North Korean sabre rattling, it is apt to think about 1987, 1997 and 2007 and what happened next.
In 1987, equity markets peaked, up more than 30% year-to-date, in mid-August. Black Monday seemed to come from nowhere two months later.
In 1997, Thailand, straining under a mountain of debt and unable to get enough hard currency to defend its currency peg against the U.S. dollar, had to let the baht float in July. Instead, it sank, bankrupting the country and sending a vicious contagion through much of Southeast Asia. Thailand and the Philippines requested IMF aid, Indonesia and South Korea were forced to follow suit in the fall, and by October the panic had spread to the developed markets.
In 2007, on August 6, a combination of overcrowded positions, leverage and complacency led to a build-up of pressure in some quantitative investment portfolios. That pressure was unleashed in a “quant quake” that rattled equity markets for a week and scarred systematic and value investors for years.
Three days later, in one of the signal moments of the credit crisis, interbank money markets suffered an unprecedented seizure after BNP Paribas had to suspend redemptions from three supposedly safe asset-backed securities funds. Within a month customers were queuing outside a major UK High Street bank trying to get their cash out.
Knutzen says: “What stands out is the capacity of financial markets to ignore stresses and strains for a long time before pricing them in all of a sudden.
“Black Monday and the “quant quake” came without any apparent warning. The subprime crisis and credit crunch were perfectly evident if you wanted to see them: Freddie Mac stopped buying subprime mortgages as early as February 2007; New Century Financial had filed for bankruptcy by April; Bear Stearns suspended redemptions from asset-backed securities funds in June, two months before BNP Paribas.
“And yet the S&P 500 Index finished July 2007 up almost 7.5 per cent year-to-date. Even after wobbling in August and November, it ended the year up 4.4 per cent. Few guessed that a five-year bull market had peaked, and that one of the most devastating crashes in financial history was about to unfold.”
Knutzen believes that recent market volatility over North Korea appears justified. “The potential human and economic cost of an exchange of fire between North Korea, the US or its allies, and the proximity of the crisis to such an important economic and geopolitical player as China, means that even moving from almost-zero probability to a slight probability of such an outcome may be enough to raise financial risk. At the same time, however, the likelihood is that this will blow over. That will likely send us back to balance-sheet and business fundamentals, still basking in the glow of two very good earnings seasons.”
He concludes: “In our view, the best lesson to take from 1987, 1997 and 2007 is that complacency and overconfidence in anyone’s ability to predict what will happen over the next week, month or year should be abandoned. Instead, here is a much more certain prediction based on our experience of those three momentous falls: the properly diversified portfolio is the one most likely to be intact in 2027, 2037 and 2047.”
Greg Bright is publisher of Investor Strategy News (Australia)