Thus far, the market’s reaction to North Korea’s missile launches has been predicated on the (allegedly) rational view that it’s sabre rattling and neither side will really let this turn into anything significantly awful. That leads to the logical conclusion that it provides a great opportunity to buy the dip in risky assets; or if you want to get cute, in Defense ETFs. After all, the cheap money party keeps on rolling, what with the Fed’s hiking almost entirely neutralised by equities rallying and credit spreads narrowing. Here’s a nice St Louis Fed chart of how mortgage rates have come down at least 25bps since the start of the year:
Same story in the Eurozone, even with the currency at two-year highs. Here’s Citi’s Financial Conditions Index – printed alongside GDP just in case we were in any doubt that growth is always and everywhere a monetary phenomenon (!):
So why should some posturing between two men with remarkably unusual haircuts give us any cause for concern?
Firstly, those haircuts are sitting atop some potentially irrational brains.
The Cold War’s M.A.D. doctrine taught us that annihilating one another was, as the name suggests, mad. Even a computer called Joshua knew that. But what if the men with their fingers on the nuclear button were less than fully rational; or if there were a miscalculation? If instead of playing noughts and crosses they thought they were playing battleships? After all, Trump, in relentlessly optimistic mood, just described the relief efforts after Hurricane Harvey as “a wonderful thing… I think even for the country to watch and for the world to watch”. He is not the Reality TV President for nothing. Always setting the scene and talking up the ratings. Meanwhile the North Korean leader has been described as “a little unhinged” by no less than former Sec of State, Condoleezza Rice. She has also been adamant that if North Korea even look like they’re getting close to being able to launch an ICBM, they must be blown off the face of the planet. And that’s from a woman with decades of experience in national security, including non-proliferation talks in the 2000s with the North Koreans themselves.
The theory then goes that the US clearly know what they’re doing behind the scenes, the North Koreans can easily be crushed, and no need to worry as we go back to buying those cheaply-funded risky assets. If you’re worried, maybe buy a safe haven for portfolio protection. But please do not under any circumstances miss out on buying the dip. As we have previously discussed, ‘We Are All Passive Now’ and the wall of money into index products is just multiplying the effect from the cheap money party. As CDOs once provided the vehicle to leverage up debt upon debt, now ETFs provide the vehicle to leverage up liquidity upon liquidity. Central banks made the price of money negative, so use that liquidity to buy more something even more liquid.
Unfortunately this propagates the mispricing of risk through the system. Where once the VIX was an indicator of risk, it’s now an asset in itself. So if North Korea accidentally sets off nuclear war, and the VIX spikes, that’s just another opportunity to sell it. It no longer represents “a forward looking indicator on volatility”, but instead just another number that mean reverts. And the mean of the past few years, ever since central banks popped up to smooth down volatility, is that nothing much happens. OK, there were little weird one off flash crashes and stuff like Brexit, but that was just over in a heartbeat, right?
There is talk of sanctions being put into place for N Korea. This is a country that ranks at 213 out of 230 on GDP per capita, just below Haiti. The population is already starving and beaten into submission. The wealth of the few is already likely to be stored below the radar. Sanctions might look like a nice next step before the pre-ordained military response kicks in. But we will hear the word “sanctions”, and decide again that we are reverting to the mean, everything is fine, nothing to see here, please move along.
We like to think we are smart. That we learn. That we wouldn’t repeat the mistakes of the past. That setting off nukes is so insane as to be impossible, rather than just highly improbable. That we wouldn’t rely so heavily on mathematical models to become trapped in a “six sigma” event. That we wouldn’t use a volatility indicator like, say, the VIX, to model future expectations of volatility.
Let’s just take a look a little more closely at what constitutes that financial conditions index we saw above:
The light blue bars are the period of the Great Moderation. Unsurprisingly they’re almost all moving in the direction of loosening. But now look at the dark blue bars, which represent the first half of this year. Some of the classic credit indicators, like 3month Euribor-EONIA (at the bottom), have reduced far more this year than they ever did in the big credit boom. The impact of the rally in the Eurostoxx has also had a bigger loosening effect. Corporate spreads have narrowed similarly. Quantitative Easing is the culprit.
Let’s leave aside whether that’s good or bad – hey at least the bar representing a mad house price boom isn’t quite as large this year, so another credit crunch looks unlikely. And instead turn back to North Korea. We can conclude:
- Market-based measures of volatility are no longer providing a signal for future volatility
- Market-based measures of credit risk are no longer providing a signal for future volatility
- Equity prices and credit spreads therefore fail to incorporate a risk premium
- Equity prices and credit spreads therefore no longer provide a signal for future volatility
- Equity prices, credit spreads, and volatility prices are all still being used to indicate loose financial conditions that implies piling into risk
So, are we deciding the sabre rattling is irrelevant because of market prices?
Or are market prices telling us to ignore the feeling in the pit of our stomach that there may be a policy mistake ahead?
Our rumbling stomachs suggest that we should be careful on the extent of risk within our portfolios.
To keep on top of North Korea from here, check out the following:
- An account of what happened last time N Korea fired a missile over Japan, in August 1998
- @StevenJGibbons on Twitter who is a seismologist monitoring underground nuclear testing – here’s his chart on how the weekend’s test measured up
- @CSIS on Twitter, the Center for Strategic & International Studies – here’s their chart on missile launches to date