Click here to read Marc P. Seidner's biography.

“God knows,” exclaimed he, at his wit’s end; “I’m not myself… I was myself last night, but I fell asleep on the mountain… and everything’s changed, and I’m changed, and I can’t tell what’s my name, or who I am!”

                                                                – Washington Irving, Rip Van Winkle

I recently had the honour of moderating the CFA Institute’s annual fixed income conference in Boston, which brought together many of the best and brightest minds in our industry. The title for the conference this year was “Rebuild Everything”, and we focused on the legacy of the global financial crisis and the “Great Recession”. The discipline of developing a theme and agenda for the conference helped coalesce for me the events of the past year and thoughts about the future. Following a nerve-wracking autumn and winter, unprecedented policy responses took effect and risk assets rallied as optimism returned to the markets. However, the secular economic headwinds resulting from deleveraging and sustained high unemployment have not diminished.

Looking Back: Crisis, Response and the Road to Recovery
While we often find ourselves declaring “what a difference a year makes”, the expression has rarely been as poignant as when referring to the past year in the investment management industry and financial markets. The investment infrastructure was shaken by scenarios that were not sufficiently conceived – including massive market failure at one extreme and massive government intervention at the other. A significant focus is inevitably on trust: trust between financial markets and regulators, brokers and counterparties, and fiduciaries and asset owners. The crisis and its aftermath have also affected asset allocation, risk management and portfolio construction.

Just twelve short months ago the financial world was paralysed by a breakdown in liquidity, and the plumbing of financial markets was clearly broken. The spread between T-bills and LIBOR (London Interbank Offered Rate), along with short-dated swap spreads and overnight index swap (OIS) spreads, reached historically wide levels. The notion that one should be more concerned with the return of capital than the return on capital was pervasive.

For those who anticipated and were prepared, great reward was at hand: Many opportunities existed in the myriad dislocations and distress in financial markets. The question now is whether the recovery has been too swift; have the animal spirits of financial markets extrapolated too far beyond the current state of economic reality?

The pendulum that swings between excessive optimism and eternal pessimism has obviously moved since earlier this year. Risk assets have appreciated markedly as the dire market consensus from last winter shifted, now favouring a virtuous cycle of encouraging market indicators. The proponents of a sustained bullish case for risk assets point to the positive economic and earnings impact from the material asset price gains since March. Additionally, a prospective bounce in GDP due to government stimulus, the inventory rebuild and the notion that businesses “over-fired” at the depths of the crisis factors into this view.

A year ago, the stimulus, widespread government guarantees and moral suasion used to counteract the effects of the subprime crisis and declining home prices were necessary, but not sufficient, factors for an economic recovery. We were just learning about the alphabet soup of policy responses: TARP (Troubled Asset Relief Program), TLGP (Temporary Liquidity Guarantee Program), BABs (Build America Bonds), CPFF (Commercial Paper Funding Facility) and QE (quantitative easing) in the form of outright purchases of mortgages and US Treasuries. In the year since the Lehman Brothers bankruptcy, the policy response has been massive in scale and scope and the impact has been unambiguous. In response to global stimulus programmes, asset prices both under and outside of the umbrella of intervention have recovered.

The introduction of the CPFF on 27 October 2008 signalled the beginning of a process in which both the US government and the Federal Reserve would go “all in” to restore liquidity and help repair the financial system.

The LIBOR-OIS spread, which captures the difference between the fed funds rate and 3-month LIBOR, peaked at 364 basis points on 10 October 2008 (source: Bloomberg). As of 22 October 2009, the spread is only 12 basis points, which is about average for the 2003–2006 period characterised by narrow risk premiums and robust economic activity. Similarly, 2-year swap spreads over Treasuries have narrowed from a peak of 165 basis points on 2 October 2008 to 36 basis points on 22 October 2009 – also about average for the 2003–2006 timeframe (source: Bloomberg).

As the money markets began to correct, the foundation for broader financial normalisation and asset price appreciation was being laid.

The following table reviews asset price returns in the post-Lehman timeframe; it indicates significant recovery across spread sectors in the fixed income market, with corporate credit leading and securitised bonds lagging. The tainted asset classes remain tainted.

Dreaming Away the Year of Financial Crisis
At a recent presentation I noticed a chart that simply did not seem right; I looked up the numbers and realised, while scratching my head, that it was indeed correct. The following chart shows the cumulative total returns for the Barclays Treasury, Investment Grade Corporate and High Yield indexes since the end of 2007.

Despite all that we have learned from the financial crisis and volatility of the past two years, the total cumulative return for these three indexes is not meaningfully different. It is as if the collective market wisdom has elected to forget that the crisis ever occurred.

This sounds a bit like the well-known story of Rip Van Winkle. One day Rip, a popular yet intolerably lazy and hen-pecked fellow, decided to go squirrel hunting. He scrambled to one of the highest points in the Catskill Mountains only to find a strange-looking gentleman with a stout keg of liquor. Rip drank liberally and soon fell into a deep slumber. After waking from what seemed like a good night’s sleep, Rip was confused by the changed landscape. He returned to his village to find that he’d slept twenty years; his wife and friends were gone and his children were grown. He told his story in a bewildered state to the amazed villagers. Unfortunately, the shock of the experience quickly wore off and Rip returned to his old, lazy ways.

Parallels to the aftermath of the Lehman Brothers bankruptcy are striking. It would be incredibly convenient to close our eyes and pretend that the period of great distress from the fall of 2008 to the summer of 2009 was a bad dream induced by over-indulging on some strange liquor, and that now we can return to our old ways. It is a tempting response but not a rational one.

The immediate crisis in the financial system is averted, but rather than correct the imbalances that arose from the shadow banking system, the programmes implemented thus far have only helped stabilise markets and reassure investors, while exposing longer-term risks. The uncertainty created by a deleveraging consumer, a compromised banking system and a wide range of potential economic outcomes should lead to higher liquidity and default premiums.

Strategies for an Uncertain Environment
As risk premiums compress, leverage is re-entering the system. Private sector term financing for risk assets seems in vogue again. Financing for a wide variety of risky collateral is becoming readily available at low funding costs, for a relatively long tenor and modest haircuts.

That said, following a year of spectacular returns, investors would be wise to refocus on the critical themes from the past year and begin to make adjustments for 2010. First, portfolio liquidity should be increased. A strategy of providing liquidity to markets that are in desperate need of it, while taking it from markets that do not, can be opportune.

Second, recognise that we are entering a period in world economies and financial markets where more is unknown than known, and many imbalances remain. Leverage has simply shifted from the private sector to the public sector. Key concerns include the sustainability of the US budget deficit, the implications for the dollar and the exit strategy from extraordinary monetary policy actions. With all these uncertainties in the markets, keep risk positions light and wait for opportunities.