What Will the Next Crisis Look Like?
One of the main topics of discussion everywhere I go is, what will the next crisis look like; along with: Where will it come from; what will the market response be; and what will be the source of the volatility? There is always volatility during a crisis.
I have been saying in writing for some time that I think the next crisis will reveal how little liquidity there is in the credit markets, especially in the high-yield, lower-rated space. Dodd–Frank has greatly limited the ability of banks to provide market-making opportunities and credit markets, a function that has been in their wheelhouse for well over a century. Given the massive amount of high-yield bonds that have been stuffed into mutual funds and ETFs, when the prices of those funds begin to fall, and the ETFs want to sell the underlying assets to generate liquidity, there will be no buyers except at extreme prices.
My friend Steve Blumenthal says we are coming up on one of the greatest buying opportunities in high-yield credit that he has ever seen – and he has 25 years of experience as a high-yield trader. There have been three times when you had to shut your eyes, hold your breath, and buy because the high-yield prices had fallen to such extreme levels. That is going to happen again.
But it is going to unleash a great deal of volatility in every other market. As the saying goes, when you need money in a crisis, you sell what you can, not what you want to. And if you can’t sell your high-yield, you end up selling other assets (like equities), which puts strain on them.
But that is not just my view. Dr. Marko Kolanovic, a J.P. Morgan global quantitative and derivative strategy analyst, has written a short essay called “What Will the Next Crisis Look Like?” and it’s this week’s Outside the Box. He sees additional sources of weakness coming from other areas, too.
Frankly, the lack of volatility is beginning to worry me a bit. Minsky constantly reminded us that stability begets instability. Stability is a pretty good word to describe the current markets – but such stability always ends in a “Minsky moment.” We don’t know when; we don’t know where it starts; but we know it’s coming.
There was a great deal of response, mostly positive, to last week’s Thoughts from the Frontline, “The Fragmentation of Society.” If you haven’t read it, you might want to. I hadn’t recognized the similarities between today and 1968 until I was reminded of them by Dr. Kolanovic and his essay.
But having lived through that era, I do get it. I think the next financial crisis will also be a trigger for a social crisis, not unlike 1968 and its aftermath. Remember, part of the follow-on was the collapse of Bretton Woods when Nixon took the US off the gold standard in 1971. Economic crises have big consequences. I will be writing about some of the current pressures again this weekend.
Until then, have a great week. Housing expert John Burns is coming by tonight, and I’m going to take him to my favorite local hole-in-the-wall BBQ hangout, called Smoke, in West Dallas. That neighborhood is starting to get gentrified, but it hasn’t changed the exquisite level of their barbecue. They serve a monster barbecued beef rib that raises your cholesterol even as you stare at it. It’s to die for. Hopefully, not literally.
Your who moved my volatility analyst,
John Mauldin, Editor
Outside the Box
What Will the Next Crisis Look Like?
By Marko Kolanovic, PhD, and
Bram Kaplan
Next year marks the 10th
anniversary of the Great Financial Crisis (GFC) of 2008 and also the 50th
anniversary of the 1968 global protests against political elites. Currently,
there are financial and social parallels to both of these events. Leading into
the 2008 GFC, some financial institutions underwrote products with excessive
leverage in real estate investments. The collapse of liquidity in these
products impaired balance sheets, and governments backstopped the crisis. Soon
enough governments themselves were propped by extraordinary monetary stimulus
from central banks. Central banks purchased ~$15T of financial assets, mostly
government obligations. This accommodation is now expected to reverse, starting
meaningfully in 2018. Such outflows (or lack of new inflows) could lead to
asset declines and liquidity disruptions, and potentially cause a financial
crisis. We will call this hypothetical crisis the “Great Liquidity Crisis”
(GLC). The timing will largely be determined by the pace of central bank normalization,
business cycle dynamics and various idiosyncratic events, and hence cannot be
known accurately. This is similar to the 2008 GFC, when those that accurately
predicted the nature of the GFC started doing so around 2006. We think the main
attribute of the next crisis will be severe liquidity disruptions resulting
from market developments since the last crisis:
·
Decreased AUM of strategies that buy Value Assets: The shift from
active to passive assets, and specifically the decline of active value investors,
reduces the ability of the market to prevent and recover from large drawdowns.
The ~$2T rotation from active and value to passive and momentum strategies
since the last crisis eliminated a large pool of assets that would be standing
ready to buy cheap public securities and backstop a market disruption.
·
Tail Risk of Private Assets: Outflows from active value investors
may be related to an increase in Private Assets (Private Equity, Real Estate
and Illiquid Credit holdings). Over the past two decades, pension fund
allocations to public equity decreased by ~10%, and holdings of Private Assets
increased by ~20%. Similar to public value assets, private assets draw
performance from valuation discounts and liquidity risk premia. Private assets
reduce day-to-day volatility of a portfolio, but add liquidity-driven tail
risk. Unlike the market for public value assets, liquidity in private assets
may be disrupted for much longer during a crisis.
·
Increased AUM of strategies that sell on ‘Autopilot’: Over the
past decade there was strong growth in Passive and Systematic strategies that
rely on momentum and asset volatility to determine the level of risk taking
(e.g., volatility targeting, risk parity, trend following, option hedging,
etc.). A market shock would prompt these strategies to programmatically sell
into weakness. For example, we estimate that futures-based strategies grew by
~$1T over the past decade, and options-based hedging strategies increased their
potential selling impact from ~3 days of average futures volume to ~7 days of
average volume.
·
Trends in liquidity provision: The model of liquidity provision
changed in a close analogy to the shift from active/value to passive/momentum.
In market making, this has been a shift from human market makers that are
slower and often rely on valuations (reversion), to programmatic liquidity that
is faster and relies on volatility-based VAR to quickly adjust the amount of
risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day
volatility, but increases the risk of disruptions such as the ones we saw on a
smaller scale in May 2010, October 2014 and August 2015.
·
Miscalculation of portfolio risk: Over the past 2 decades, most
risk models were (correctly) counting on bonds to offset equity risk. At the
turning point of monetary accommodation, this assumption will most likely fail.
This increases tail risk for multi-asset portfolios. An analogy is with the
2008 failure of endowment models that assumed Emerging Markets, Commodities,
Real Estate, and other asset classes are not highly correlated to DM Equities.
In the next crisis, Bonds likely will not be able to offset equity losses (due
to low rates and already large CB balance sheets). Another risk miscalculation
is related to the use of volatility as the only measure of portfolio risk. Very
expensive assets often have very low volatility, and despite downside risk are
deemed perfectly safe by these models.
·
Valuation Excesses: Given the extended period of monetary
accommodation, most of assets are at their high end of historical valuations.
This is particularly true in sectors most directly comparable to bonds (e.g.,
credit, low volatility stocks), as well as technology- and internet-related
stocks. Sign of excesses include multi-billion dollar valuations for smartphone
apps or for ‘initial crypto- coin offerings’ that in many cases have very
questionable value.
We believe that the next financial
crisis (GLC) will involve many of the features above, and addressing them on a
portfolio level may mitigate the impact of next financial crises.
What will
governments and central banks do in the scenario of a great liquidity crisis?
If the standard rate cutting and bond purchases don’t suffice, central banks
may more explicitly target asset prices (e.g., equities). This may be
controversial in light of the potential impact of central bank actions in
driving inequality between asset owners and labor (e.g., see here). Other ‘out
of the box’ solutions could include a negative income tax (one can call this
‘QE for labor’), progressive corporate tax, universal income and others.
To
address growing pressure on labor from AI, new taxes or settlements may be
levied on Technology companies (for instance, they may be required to pick up
the social tab for labor destruction brought by artificial intelligence, in an
analogy to industrial companies addressing environmental impacts). While we
think unlikely, a tail risk could be a backlash against central banks that
prompts significant changes in the monetary system. In many possible outcomes,
inflation is likely to pick up.
The next crisis is also likely to
result in social tensions similar to those witnessed 50 years ago in 1968. In
1968, TV and investigative journalism provided a generation of baby boomers
access to unfiltered information on social developments such as Vietnam and
other proxy wars, Civil rights movements, income inequality, etc. Similar to
1968, the internet today (social media, leaked documents, etc.) provides
millennials with unrestricted access to information on a surprisingly similar
range of issues. In addition to information, the internet provides a platform
for various social groups to become more self-aware, united and organized.
Groups span various social dimensions based on differences in income/wealth,
race, generation, political party affiliations, and independent stripes ranging
from alt-left to alt-right movements. In fact, many recent developments such as
the US presidential election, Brexit, independence movements in Europe, etc.,
already illustrate social tensions that are likely to be amplified in the next
financial crisis. How did markets evolve in the aftermath of 1968? Monetary
systems were completely revamped (Bretton Woods), inflation rapidly increased,
and equities produced zero returns for a decade. The decade ended with a
famously wrong Businessweek article ‘the death of equities’ in 1979.
0 comments:
Publicar un comentario