END OF AN ERA FOR IRRATIONAL COMPLACENCY IN MARKETS / THE FINANCIAL TIMES MARKETS INSIGHT

End of an era for irrational complacency in markets

A ‘Goldilocks’ period for asset prices with fantastic returns may not last another year

Alberto Gallo


The Vix index of volatility is at its lowest level since its inception © FT montage; Bloomberg


Ten years after the crisis, volatility and fear have disappeared from markets. A synchronous global expansion coupled with persistently loose monetary policy produced a Goldilocks era for asset prices, culminating in fantastic returns in 2017. Will it last for another year? The short answer is: we have reasons to be cautious.

Several macro analysts have called this an environment of rational exuberance. Volatility and asset prices are justifiably low, they say, given healthy macroeconomic conditions. Instead, we believe markets may be in a period of irrational complacency.

The signs are widespread. Yields on European junk bonds have fallen below US Treasuries. Emerging market countries with a history of default, such as Argentina, have issued 100-year bonds.

Facebook, Amazon, Apple, Netflix and Snapchat together are worth more than the whole German Dax. Banks are again marketing CDOs. Cash-park assets including property, art, collectibles and cryptocurrencies are soaring in a parabolic fashion, like life rafts in a sea of central bank liquidity.

Not only have asset prices soared, volatility is at rock bottom too: the S&P 500 index just experienced the lowest amount of swings in the last 50 years. Investment strategies betting on a stable market have grown exponentially since the start of quantitative easing in 2009. We estimate $60bn capital in bets on low volatility and as much as $2tn that indirectly relies on stable volatility for performance.

The combination of high asset prices, short volatility bets and herding, confirmed by IMF data, means losses may be more concentrated in a tail scenario. While regulators have focused on strengthening banks over the past few years, the largest risks may have moved to capital markets. Price action in late November provided a small-scale preview of what an unwind of goldilocks trades would look like: EM, tech stocks and utilities moving down in tandem with long-end Treasuries and gilts.

There are three ways the current goldilocks era may come to an end in 2018. One ending could materialise if central bankers turn more cautious on the financial stability risks fuelled by loose policy. The People’s Bank of China and some US Federal Reserve FOMC members have already raised red flags. As the recovery matures, new leadership at the helm of the Fed and later at the European Central Bank could mark such a change of tack towards faster monetary normalisation.RecommendedPolitics is turning the screws on central banks’ easy money policyNeil Woodford warns of stock market ‘bubble’Will stock markets end a stellar year in style?

Another risk could be a return of inflation. Even though technology, demographics and globalisation are still likely to cap reflationary pressures, betting against the Phillips Curve (the link between unemployment and inflation) may become riskier as US unemployment falls below 4 per cent and oil prices rise. If inflation accelerates, the spillover from rising term premia in interest rates could disrupt several other carry trades. The real endgame, however, may come from the will of the people — politics.

The current combination of monetary debasement, populism and social unrest is neither a new phenomenon nor a coincidence. The late Roman empire shaved silver coins as it disintegrated; Henry VIII replaced silver coins with copper to pay for wars against France and Scotland; the British empire allowed double-digit inflation to erode bondholders’ wealth following the War of Independence; the Weimar Republic precipitated an inflation spiral.

Comparing these examples to QE may sound extreme. Yet the biggest debasement in history may be the one we are experiencing now under the form of a $20tn central bank experiment, which is de facto depreciating money by boosting the price of all assets it can buy.

Monetary policy has increased inequalities between the rich and poor, the old and the young and between large cities and suburban peripheries left out of the recovery. Brexit, Trump’s plan to exit trade agreements and the calls for independence across European regions all envision a return to past glory with the use of national borders, identifying an external enemy to polarise people’s angst and pursue disruptive policies in the process.

Absent redistributive policies to rebalance inequality and promote social mobility, excess spending and protectionism from populist regimes are likely to result in higher public debt, higher inflation and losses for investors.

Economist Rudi Dornbusch noted that crises take a much longer time coming than you think and then they happen much faster than you would have thought. Today’s markets price in that earnings will keep rising, volatility will stay low despite rising geopolitical risks and central bankers will continue to support growth without generating inflation. The Goldilocks party may go on a little longer but we all know how it will end.


Alberto Gallo is partner at Algebris Investments and portfolio manager for the Algebris Macro Credit Fund