The Irreverent Economist

Great Moderation?

The placid state of global financial markets—with measures of equity volatility near all-time lows—belies undercurrents of growing inequality, rising social unrest, and heightened political instability.  These undercurrents are occurring against the backdrop of a highly leveraged global economy and financial system.  Contrary to what markets are telling us, the range of possible outcomes seems not only wide, but skewed to the downside.  What is going on here?

Ironically, the precarious state of our financial, economic and social systems has fostered a belief that asset prices have to remain stable, because the alternative is too worrying to contemplate.  Over the past several decades, officials have responded to every economic downturn or episode of financial instability by facilitating the rollover of existing debt (thus mitigating defaults), while encouraging even more credit creation, and further inflating asset prices.  Every time we go through such a cycle, the consequences of not continuing to feed the beast become more extreme.  Our economic scenario is, not coincidentally, analogous to our environmental situation.  We have engaged in financial stabilization (forest fire suppression, rebuilding communities against rising tides, etc.) at the cost of ever more extreme financial imbalances, a buildup of forest underbrush, and larger flood-prone communities—which lead to cataclysmic results down the line.  As Nassem Taleb explained so well in his book Antifragile, well-intentioned policymakers are courting disaster.  With an eye toward the guillotine of history, our Federal Reserve, the European Central Bank, and the Communist Party of China micromanage mere fluctuations in the growth patterns of the global economy.  In short:  moral hazard has reached an extreme.

Who in their right mind wouldn’t respond to these incentives by buying risky assets and selling volatility?  Knowledge that the government cannot afford to let the economy or markets fall acts as a propellant to risk taking.  After all, if policymakers always have your back, why should you buy insurance against a fire, flood, hurricane, or potential market decline?  Why hold cash as a precaution?  The “markets” will penalize you, cautious fool. Good citizens buy anything and everything that the authorities prod them to own. Party on!  Naturally, the price of market insurance (volatility) will fall in such an environment, as equities rise.

On certain valuation metrics (such as the median price/revenue ratio of S&P 500 Index constituents) US equity markets are far more expensive than they were during the DotCom bubble.  Implied volatility recently reached its lowest readings since 1993.  As the bull market has continued, market corrections and corresponding spikes in volatility have become progressively less severe and enduring.  Speculative short positions in VIX (implied volatility) futures are at an all-time high, indicating that investors anticipate further declines in market risk.  We hear distinct echoes of 2006-07, when subdued economic and market volatility was heralded as the “Great Moderation,” leading us to a halcyon world.  Well, no.

Two concurrent themes, the growth of quantitative and passive investing, also drive investors into this “volatility vortex.”  Quantitative mandates that target levels or ranges of portfolio volatility (e.g. risk-parity funds) must increase their exposure to risky assets as markets become calmer, simply to hit their volatility targets.  Meanwhile, the growth of passive investment strategies diminishes trading activity from active funds and retail investors.  For most investors, passive strategies are a good thing—unless/until market prices deviate significantly from fundamentals.  Unfortunately, most passive funds push investors, by virtue of their market cap weightings, into the most expensive securities & sectors, which are prone to larger downdrafts when fundamentals eventually reassert themselves.  Since quantitative and passive funds now represent a significant fraction of daily trading volume, these self-reinforcing dynamics are driving volatility ever lower.

How this all ends depends greatly on one’s faith in central bankers’ willingness and ability to control economic and market outcomes.  We believe that, despite outward appearances of calm and control, they are apprehensive of what a severe downturn in the global economy might mean for the global financial system.  In the meantime, Yellen, Draghi, Kuroda et. al. will attempt to have their cake and eat it too—by “normalizing” policy in a world that is anything but normal.  Good luck and best wishes to us all.

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