Wall Street’s crash in 1987 has an ominous parallel with today’s global markets
‘The disconnect between asset prices and macro-political and policymaking developments is indeed striking’
Thursday marks the 30th anniversary of “Black Monday”, the stock market crash on October 19, 1987 when US stocks plunged more than 20 per cent, their sharpest-ever one-day decline.
Not surprisingly, equity market bears are drawing parallels between the dramatic sell-off in 1987 and today’s frothy conditions in US stock markets which are enjoying their second-longest bull run ever and which are in bubble territory according to most valuation measures.
Richard Thaler, a University of Chicago professor who last week won the Nobel Prize for economics, echoed the views of many market commentators when he told Bloomberg TV: “We seem to be living in the riskiest moment of our lives and yet the stock market seems to be napping. I admit to not understanding it.”
The disconnect between asset prices and macro-political and policymaking developments is indeed striking. While there are numerous examples of market mis-pricing, the three most important ones are:
• US monetary policy: The Federal Reserve and the bond market are sending contradictory signals. While markets are currently assigning an 87 per cent probability to another interest rate hike in December, bond investors and Fed policymakers differ sharply when it comes to the outlook for monetary policy in 2018.
While the Fed anticipates three more rate hikes next year, futures prices are assigning a more than 50 per cent probability to rates remaining unchanged by June and an 8 per cent chance that they will be lowered by then. Even by September, the highest odds (nearly 40 per cent) are for just one 25 basis point hike.
As Datatrek Research, an economic consultancy, notes: “Why the split between Fed commentary and market pricing? One word: inflation.” Markets believe the Fed is far too optimistic on the path of inflation, increasing the risk of a major “policy mistake” if the Fed tightens (or is perceived to tighten) prematurely. Add to this the uncertainty surrounding both the prospects for US tax reform and the new leadership at the Fed once Chairwoman Janet Yellen’s term ends in February, and the discord between markets and the Fed could increase further.
• Political risks: How much more political risk will it take for markets to come under significant strain? The growing disconnect between mounting political and geo-political threats to sentiment and elevated asset prices is one of the clearest signs of complacency in markets. The insouciance is all the more striking given the potential for politics to influence asset prices.
The British pound has become, in the words of HSBC, a “political currency” whose performance is heavily determined by the twists and turns in Britain’s arduous negotiations to leave the European Union. Bullish bets on sterling – which shot up 11.6 per cent against the dollar between early March and early September – have already backfired, with the pound down more than 3 per cent over the past month because of the mounting risk of the UK crashing out of the EU with no trade deal in place. Make no mistake, Brexit risk is being significantly underpriced.
The mother of all political risks, Donald Trump’s crisis-ridden presidency, is even more underpriced given its far-reaching implications for monetary policy (Trump is now considering whom to appoint as Fed chair), trade policy, foreign policy (particularly towards North Korea) and, most importantly, domestic politics.
• Ultra-low volatility: The most worrying disconnect, however, is the dramatic decline in financial volatility to historically low levels despite the plethora of risks confronting markets and the global economy. The evaporation of volatility has had a profound impact on markets, encouraging investors to place huge bets on volatility remaining subdued.
While these bets, known as “shorting vol” in Wall Street slang, have proved extremely profitable over the past several years, a sudden reversal of short volatility trading strategies – which have become one of the most crowded trades – would exacerbate the sell-off as investors scramble to buy protection against sharp declines in asset prices.
Yet so convinced have investors become that every bout of market turbulence will be quickly followed by a long period of calm that they continue to ratchet up their bets that the tranquillity will persist. At some point, however, short vol trading strategies will backfire spectacularly, amplifying selling pressures and increasing the risk of a full-blown financial crisis.
While asset prices could remain elevated for some time yet, the removal of monetary stimulus by the world’s leading central banks will stretch the resilience of markets to breaking point.
Few investment strategists see another Black Monday in the offing, yet the disconnect between markets and fundamentals is becoming more troubling with each passing day.
Nicholas Spiro is a partner at Lauressa Advisory