Looking back on life, do you find it’s the small things upon which your memory lingers? At least, they seemed small at the time, but on reflection they turned out to be big. Really big. Life-changingly big. The phone call never returned. The stranger’s eye never caught. That time he ignored the cat. The birthday she missed.
We like to think it’s about the big set pieces: births, marriages, deaths, promotions, moving house. But in reality, it’s the unopened door that really changes the path. The road less travelled. Forks in the road turn up, but we only see them once we have sailed past.
Markets, being the prices of a probabilistic path of future outcomes, are supposed to spot all these forks and factor them in. For the past twenty years or so, absent the financial crisis, they have done that rather efficiently. A tweak to an inflation forecast here; a shift in growth patterns there. Of course, we all know what happened when something couldn’t be priced: the global economy came crashing down. What was a mortgage worth? What were a number of them bundled together worth? Or a product modelled on a bundling-together of a bundling-together? It may have been zero, or it may have been something, but the problem is that the market couldn’t price it. It was only when a bid returned to the market that some kind of sanity dawned.
We think we are far from that now, of course. Banks have rebuilt balance sheets. Regulators have created new supervisory regimes. Complex products are in retreat.
Yet something odd is going on, isn’t it?
The endless spiral upwards in stock markets just feels too much, doesn’t it? Even as we all understand that the world is in decent shape, economies are doing OK, most companies are alright, leverage is high but manageable… it just feels like it’s too quiet out there. As BAML have flagged up in this chart, we are now in the 4th longest consecutive period without the S&P experiencing a 5% pullback:
Why does this feel odd? If you look back at the decades that feature in BAML’s top 20 chart, the one with the most instances of these long quiet periods occurs in the 1990s, with the 2010s coming in second place. The 1990s were pretty volatile in places. That suggests we should be fearful: that after a long period of calm, we cannot help but fall into a period of shocks. And it usually comes from the small things. Something we didn’t even think about that much at the time. Was it clear that the Asian financial crisis would ultimately lead to the collapse of a supposedly brilliant market-risk-managing hedge fund, via a Russian debt default, that would almost bring down a US bank?
Afterwards, it’s obvious. The forks in the road were clear. Why didn’t anybody see them?
And now, we have some pretty clear indicators ahead:
- Inflation is turning
Chinese PPI was doing a great job of rushing back into positive territory, but it has stalled. World CPI is, as it often does, following suit:
2. Volatility is too low for the risks ahead
Here is our favourite cross asset vol chart, normalised for the recent lows in volatility of the summer of 2014. We haven’t quite hit all time lows in all volatilities but we are darn close. And unusually, all assets are behaving like this. There is very little volatility expected in stocks, bonds or currencies.
That might be absolutely fine, of course. And indeed, why worry? The monetary stimulus tap keeps on giving. Let’s not forget this chart of total central bank assets:
But we are in something more pernicious. We are now in a positive feedback loop: risky assets keep going up; financial conditions loosen; so volatility compresses; so risky assets go up, and so on. Just check out this GS chart on how US financial conditions continue to ease, even in a period over which the central bank has actually been hiking, and discussing running off the assets on its balance sheet:
Look at what’s causing the loosening: equities rallying and spreads tightening are a decent chunk of it. Along with the drop in Treasury yields – which once again comes from the hunt for yield that is generated precisely by the tightening of those credit spreads.
So why is volatility too low for the risks ahead? Well there happens to be a couple of forks in the road up ahead…
3a) Central Banks
Well for a start there is the fact that the monetary taps ARE turning off. The recent speech by the ECB’s Coeure celebrated the efficacy of QE in a kind of farewell retrospective. Draghi takes the floor in Jackson Hole in a few weeks, and ahead of the German election in September, the smart money has to be on him providing an eloquent argument for stepping back from QE. Not least because the Germans, quite specifically, are running out of bonds to buy. Then we have more and more noises from Japan about their QE. First we had “some BOJ officials” a week ago hinting they are “increasingly concerned” about the scale of their ETF purchases, followed closely by similar criticism from the head of Japan’s Stock Exchange no less. With PM Abe facing plunging support following a scandal, will he survive to retain his choice for BOJ Governor once Kuroda’s term ends in April next year?
This is where we bleed into the joker in the pack. For all the talk of economics or the carry trade, the single biggest elephant in the room is politics. This is the fork on the road that it would appear everyone is missing. It’s great to think about where US or Japanese interest rates will be in a year’s time, but what if the people leading those central banks have gone completely? Trump just told the Wall Street Journal that Yellen is still in the running for the job, but hey so is the guy who’s supposed to be finding her replacement, Gary Cohn. And why does Trump like Yellen?
‘I’d like to see rates stay low. She’s historically been a low-interest-rate person’
Riiiiight. M’kay. Thus far the market has ignored that comment. Just like it ignored that Trump might struggle to get deals done in Congress, preferring instead to ride the reflation bandwagon following his surprise election. And just like it then ignored the rumblings of Russian-linked scandals, aside from a day or two of wobbling. Why? Because it’s difficult. Because it can’t be priced.
Politics is the securitised synthetic CDO squared of your nightmares. Not least when the probability path of anything political ebbs and flows with the national mood.
The BIS, as ever, have nailed this in their latest annual report. Politics, they say, matters. More than central bank meetings:
Despite this, there is a sense that political risk has gone away. We think it’s over because those events were specific one-offs. A referendum. An election. Now, though, comes the messy business of governing. This is even harder for markets to deal with. It’s not a binary one-off event. It shows how far we have sunk into our own mindset that the BIS would even compare an election to a monetary policy meeting. The UK referendum has kicked off a tumultuous realignment in UK politics, that is up-ending conventional wisdom and completely throwing open how the UK economy will look in a few months’ time. It didn’t end there. It only just started. We now have to consider the non-zero risks of: The UK leaving the EU without a deal; the UK not leaving at all; a Jeremy Corbyn government; and another election before the end of the year. For a country running a deficit, these are serious risks. They may be darn hard to price, but they are up there ahead, looming. Great big forks in the road. Great big choices that will change the course of history.
For now, though, it’s buy dips, wear diamonds. Every indicator you can see is telling you to do so… so why wouldn’t you? I mean, you’ll change course when the big signal comes, right?
Repeat as you fall into sleep… The phone call never returned. The stranger’s eye never caught. That time he ignored the cat. The birthday she missed.
The big fork is coming. And the US Dollar hitting 13 month lows just as the administration starts to really fall apart? That’s just the start of it.