It’s so tranquil, we must be nearing the death stage for global asset prices
‘Crisis-spotters must contend with increasingly uninformative and deceptive measures of sentiment’
In 1989, the late Herb Stein, a well-known American economist who served as chairman of former president Richard Nixon’s Council of Economic Advisers, wrote that “if something cannot go on forever, it will stop”.
His adage became known as “Stein’s law” and is often cited by commentators who warn of unsustainable trends in financial markets and the global economy. While Stein’s remark may seem like a statement of the blindingly obvious, it is an aphorism that has never rung more true than it does today.
The ability of markets to climb a “wall of worry” and turn a blind eye to the plethora of vulnerabilities facing the global economy – from the rapid build-up of corporate debt in China to the dangers in exiting ultra-loose monetary policies, particularly in Europe and Japan – seems to know no bounds.
This makes it nigh impossible for economists and investment strategists to predict with any degree of certainty the catalysts and precise timing of the next major financial crisis.
It was the influential economist John Maynard Keynes who famously observed that “the market can stay irrational longer than you can stay solvent”. Yet not even Keynes could have envisioned the extent to which the prices of financial assets have become distorted by the ultra-accommodative monetary policies of the world’s main central banks following the 2008 financial crash.
While central banks, in particular the US Federal Reserve, the world’s most influential monetary guardian, deserve enormous credit for helping restore confidence in the financial system by slashing interest rates and embarking on aggressive programmes of quantitative easing, their policies have bred complacency in markets. Investors have grown accustomed to the backstops provided by central banks, particularly during periods of severe financial stress, such as the euro-zone debt crisis in 2011-12 and the turmoil engendered by fears about China’s economy and policy regime in the second half of 2015.
These backstops have suppressed volatility in markets, making it even more difficult for experts to forecast the next crisis.
The closely watched Vix index, Wall Street’s “fear gauge”, which measures the anticipated volatility in the benchmark S&P 500 Index over the next month, has been trading significantly below its historical average of 20 points since the days leading up to Donald Trump’s upset victory in the US presidential election on November 8. The Vix currently stands at just 13.5 points, close to its historic low struck in 1993.
Indeed, such is the extent of the QE-induced decline in volatility over the past several years – and, more importantly, the conviction among many traders and investors that the calmness will persist – that the tranquillity itself has turned into an actively traded and popular asset.
International investors – initially speculative ones such as hedge funds, but more recently long-term institutional investors – have been placing big bets on volatility remaining subdued for the foreseeable future. These bets, known as “shorting”, or selling, volatility in Wall Street parlance, have proven extremely profitable and are suppressing volatility further.
Yet the more subdued the volatility, the greater the distortion in asset prices and, once financial turmoil finally erupts, the bigger the scope for a much more disorderly sell-off than would otherwise be the case if investors had not been selling volatility over the past several years.
What is clear is that the Vix has become a poor gauge of investors’ sensitivity to the vulnerabilities and threats in the global economy that could precipitate the next crisis.
Crisis-spotters must contend with increasingly uninformative and deceptive measures of sentiment when trying to pinpoint which of the many potential triggers of the next crisis is the one most likely to provoke the sharpest and most sustained deterioration in market conditions.
This is a huge challenge, particularly since it could well be a “black swan” event (one that is entirely unexpected and therefore virtually impossible to predict) that sparks the next crisis.
Still, one of the most probable sources of financial turmoil is the removal of monetary stimulus, already under way, albeit gradually, in the US and likely to begin next year in the euro zone and possibly Japan. If mishandled by central banks, the reaction in markets could be severe.
Then again, who would have predicted at the time of the Fed-induced “taper tantrum” in 2013 that global equities would be standing at near-record highs five months after an arch-populist was elected US president and as the Fed picks up the pace of interest rate rises?
Markets could stay irrational for some time yet.
Nicholas Spiro is a partner at Lauressa Advisory