Subprime and Short Vol

Doug Nolan

February 6 – Wall Street Journal (Spencer Jakab): “Only very rarely has a trade gone from being so good to being so bad so quickly. Among the most profitable trades during the bull market has been to short volatility, essentially betting the market would get calmer and stay calm. An exchange-traded instrument, the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, grew to $2 billion by harnessing futures on the Cboe Volatility Index. The note, with the symbol XIV, had a 46% compound annual return from its inception in 2010 to two weeks ago. Late on Monday, though, the combined value of the note fell 95% to less than $15 million as trading was halted early Tuesday… The product contained the seeds of its own destruction. By selling short futures on the Cboe Volatility Index, or VIX, it profited in two ways in the recent market calm. It took advantage of the typical ‘contango’ present in the market—longer-dated futures tended to be higher-priced than VIX itself and fall in value. Constantly rolling over the position to sell more distant futures was a moneymaker. Another was simply profiting from volatility falling to near record lows.”

The collapse of two Bear Stearns structured Credit funds in July 2007 marked a critical (mortgage finance) Bubble inflection point. These funds were highly leveraged in (mainly “AAA”) collateralized debt obligations (CDOs), as well as being enterprising operators in Credit default swaps (CDS). It was essentially a leveraged play on the relatively stable spread between subprime mortgage yields and market funding costs. It all worked splendidly, so long as stability was maintained in the subprime mortgage marketplace. This strategy blew up spectacularly when confidence in subprime began to wane (rising delinquencies) and lenders to Bear Stearns (and others) turned skittish. Liquidity in subprime-related securities evaporated almost overnight.

About everyone downplayed the relevance of subprime. It was a “small” insignificant market. 

U.S. economic fundamentals were robust, while cracks had yet to become visible either in prime mortgages or U.S. housing more generally. Indeed, the decline in market yields heading into 2008 worked for a while to support home and asset prices, including an equities market rally and a new record high for the S&P500 in October 2007.

Missing in the analysis was the critical role structured finance had assumed throughout the mortgage marketplace, especially late in the cycle. CBBs during the mortgage financial Bubble period focused often on “The Moneyness of Credit” and “Wall Street Alchemy.” Literally Trillions of risky mortgages were being transformed into perceived safe and liquid “AAA” securities. Sophisticated risk intermediation fundamentally altered demand dynamics for high-risk loans.

Perceived money-like subprime securities enjoyed virtually insatiable demand in the marketplace, providing prized high-yield fodder for a late-cycle manic episode of leveraged speculation. And so long as sophisticated risk intermediation was running hot, there remained readily available inexpensive mortgage Credit to sustain home price inflation and system liquidity more generally. It became of case of the greater the quantity of risky loans intermediated through Wall Street’s sophisticated structures - the lower the cost and the greater the liquidity in the booming market for mortgage risk “insurance”. With readily available cheap insurance, why not aggressively speculate and leverage?

Finance flooded into structured products, with 2006 seeing a staggering $1.0 TN of subprime-related CDO issuance. The insatiable demand for these higher-yielding instruments ensured even the weakest Credits (devoid of down-payments) would bid up home prices across the country. And years of housing inflation ensured risk model forecasts of minimal future loan losses – and “AAA” ratings galore. In a critical Bubble “Terminal Phase” dynamic, Credit Availability loosened dramatically as borrowing costs declined – ensuring a final precarious “blow-offs” in Credit, home inflation and asset price more generally. In the end, the parabolic expansion of systemic risk created untenable demands on the financial system and risk intermediation, in particular.

Underpinning mortgage finance Bubble Dynamics was the deeply held market view that Washington (the Fed, Treasury, GSEs and Congress) would never tolerate a housing bust. This perception ensured the GSEs would continue to insure mortgages and borrow at risk-free rates despite the reality that they were effectively insolvent. It was this deeply embedded perception and the booming prime mortgage marketplace that over time cultivated all the nonsense that unfolded in subprime structured finance. The Washington backstop ensured that unlimited cheap Credit remained readily available even after years of mounting excess. The resulting “Moneyness of Credit” nurtured major pricing distortions in Trillions of securities.

For nine long years now, CBB analysis has posited “the global government finance Bubble,” “The Moneyness of Risk Assets” and the “Granddaddy of all Bubbles” theses. I believe the Bubble has likely been pierced. The spectacular blowup of all these “short vol” products is a replay of subprime in the summer of 2007 - just so much bigger and consequential. The “insurance” marketplace has badly dislocated, concluding for now the environment of readily available cheap market protection.

Structured finance was instrumental in ensuring the marginal subprime buyer could access the means to keep the Bubble inflating, even in the face of inflated home prices increasingly beyond affordability. These days, all these structured volatility products have been key to enormous pools of “money” chasing inflated securities prices increasingly detached from reality.

A Paradox of Dysfunctional Contemporary Finance: The higher home prices inflated (and the greater systemic risk) the cheaper it became to “insure” mortgage Credit risk. More recently, the higher stock prices have inflated (and the greater systemic risk), the cheaper it has been to “insure” equities market risk. These highly distorted “insurance” markets became instrumental in attracting the marginal source of finance fueling late-stage “Terminal Excess” throughout the risk markets.    

Variations of these “short vol” strategies have essentially been writing flood insurance during a prolonged drought. Key to it all, global central bankers for the past nine years have been intently controlling the weather.

In the mortgage finance Bubble post-mortem, the Fed convinced itself that bad bankers and weak regulation of mortgage lending were the villains. In reality, the overarching issue was found within the financial markets: confidence that policymakers were backstopping the markets fomented price distortions, self-reinforcing speculative excess and untenable leverage. 
Failing to learn the critical lesson from the Bubble period, radical post-crisis monetary policymaking fostered the perception that equities and corporate Credit were safe and liquid money-like instruments (“Moneyness of Risk Assets”), in the process profoundly transforming market demand, price and speculative dynamics.

Importantly, activist reflationary policymaking ensures that speculative leveraging becomes a prevailing source of liquidity throughout the markets and in the overall economy. When de-risking/de-leveraging dynamics took hold in 2008, a deeply maladjusted system immediately became starved of liquidity. Dislocation (spike in pricing and illiquidity) in the “insurance” markets – subprime in 2007 and equities in early-2018 – marked a critical juncture in risk-taking, leveraging and overall system liquidity.

February 7 – Bloomberg (Dani Burger): “For a fledgling asset class whose idiosyncrasies are understood by few, there sure is a lot of money swirling around in volatility trades. Investment strategies and products married to market swings were thrust front and center by the worst market meltdown in seven years, in which the Cboe Volatility Index surged to its highest level since 2015.
VIX-related securities were halted, volatility-targeting quants blamed, and options trading in benchmarks for turbulence ballooned. Too big to ignore, it’s an asset class in its own right, with the might to push around the broader market. Getting a grip on it has confounded strategists and managers alike… There are two categories of securities linked to price turbulence, roughly speaking: ones tied to the VIX directly, and others that take their cue from the volatility of individual stocks. Altogether, estimates for the space are anywhere from $1.5 trillion to $2 trillion. Beyond that is the options market, which itself is an implicit bet on swings in shares.”

Things turn crazy near the end of major Bubbles – and The Bigger the Crazier: One Trillion of subprime CDO issuance (2006) and today’s “anywhere from $1.5 trillion to $2 trillion” of volatility trades is some real financial insanity. The Fed’s strategy has been to aggressively reflate and entrust “macro-prudential” regulation for safeguarding financial stability. Why has there been zero effort to regulate the proliferation of highly leveraged “short vol” products?

It was an extraordinary week that offered overwhelming support for the Bubble thesis. In particular, the risk market “insurance” marketplace was in fact an accident waiting to happen. 
Moreover, today’s Bubble is very much a global phenomenon.

The S&P500 sank 5.2% this week. Yet this pales in comparison to the Shanghai Composite’s 9.6% drubbing. Hong Kong’s Hang Seng Index fell 9.5%, with the Hang Seng Financials down 12.3%. Equities were bloodied throughout Asia. Japan’s Nikkei 225 index sank 8.1%. Stocks were down 7.8% in Taiwan and 6.4% in South Korea. European equities were under pressure as well. Germany’s DAX dropped 5.3%, France’s CAC 40 5.3%, Spain’s IBEX 5.6%, and Italy’s MIB 4.5%. In Latin American equities, Brazil fell 3.7%, Mexico 5.2%, Argentina 7.6% and Chile 4.8%.

U.S. equities mounted a decent Friday afternoon rally, with the S&P500 (reversing an almost 2% inter-day decline) ending the session with a gain of 1.5%. Perhaps the U.S. market recovery will spark a Monday reversal in Asia and Europe. With option expiration next Friday, it would not be uncharacteristic for a market rally to pressure recent buyers of put protection into expiration. It also wouldn’t be all too surprising to see some players ready to sell an elevated VIX with the first semblance of stability. It’s worked so many times in the past.

It was an extraordinary week in several respects: the VIX traded as high as 50, intense selling of equities across the globe and a meaningful widening of high-yield corporate Credit spreads. 
Considering the spike in equities volatility, the corporate debt market held together reasonably well (certainly bolstered by ongoing large ETF inflows). Investment-grade CDS did jump to five-month highs. Junk bond funds suffered outflows of $2.743 billion, helping along with the VIX spike to spark the biggest jump in high-yield CDS in about a year. Global bank CDS moved higher this week (from compressed levels), led not surprisingly by Deutsche Bank and some of the other major European lenders. The GSCI Commodities index sank 6.1%, with crude down $6.25, silver falling 3.4% and copper sinking 4.8%.

Curiously, the Treasury market is struggling to live up to its safe haven billing. Notably, in all the market mayhem, 10-year Treasury yields actually added a basis point to 2.85% (up 45bps y-t-d). Long-bond yields rose seven bps to 3.16%. German bund yields gave up only two bps this week, with yields still up 32 bps y-t-d. So not only did the cost of market “insurance” hedges spike higher, Treasury holdings this week did not provide their traditional hedging function. This made it an especially rough week for “risk parity” and other leveraged strategies that have relied on a Treasury allocation to help mitigate portfolio risk.

The risk versus reward calculus has rather quickly deteriorated for risk-taking and leveraging. Markets have turned much more volatile and uncertain – equities, fixed-income, currencies and commodities. The cost of market “insurance” has spiked, the Treasury market safe haven attribute has been diminished and various market correlations have increased, certainly including global equities markets. “Risk Off” has made a rather dramatic reappearance. How much leverage is lurking out there in global securities and derivatives markets?

Next week is tricky. I would generally expect at least an attempt at a decent rally prior to options expiration. But at the same time, my sense is that market players are especially poorly positioned for the unfolding “Risk Off” backdrop. A break of this week’s trading lows would likely see another leg down in the unfolding bear market. And with derivatives markets already stressed, major outflows from the ETF complex would be challenging for less than liquid markets to accommodate.

It took about 15 months from the collapse of the Bear Stearns structured Credit funds in 2007 to the market crisis in the fall of 2008. Many still believe that crisis was completely avoidable had the Fed intervened to save Lehman. Yet it was much more of an issue of Trillions of dollars of mispriced securities, dysfunctional risk intermediation, enormous accumulated financial and economic risks, and the inevitability of the financial system’s inability to sustain the necessary quantities of new Credit to keep the Bubble inflating (following parabolic “terminal” excesses).

Similar issues overhang financial systems and economies today, but on an unprecedented global scale. The Treasury market is a glaring difference between 2018 and 2007. After trading as high as 5.30% in June 2007, 10-year Treasury yields sank to 3.84% by November. Fed funds were at 5.25% throughout the summer of 2007, with the Fed slashing rates 50 bps on September 18th and another 50 bps before year-end. I would posit that it stretched out five quarters from “inflection point” to crisis because the Fed back in 2007 still had significant room to push bond and MBS yields lower (prices higher). The Bernanke Fed enjoyed flexibility that the Powell Fed does not. The Treasury ran a $161 billion deficit in fiscal-year 2007.

Things Just Got Too Crazy – completely out of hand. The equities melt-up, the crypto currencies, the technology/biotech mania, M&A, leveraged loans, the return of booming structured finance and the collapse in risk premiums throughout global Credit markets. The Dow is going to a million – along with Bitcoin. Trillions of unending ETF flows. The VIX down to 8.56. Caution to the wind – epically. China Credit.

With another $2.7 TN of QE in 2017, central bankers pushed the envelope too far. And, importantly, Washington (and governments around the world) just went nuts with the view that spending is wonderful and deficits don’t matter. Too many years of central bank-induced over-liquefied markets incentivized excess, from Wall Street to Silicon Valley to Washington to Beijing to Tokyo and Frankfurt. Markets at home and abroad completely failed as mechanisms to discipline, to self-adjust and to correct.

There will be a very steep price to pay.

Souped up growth

America’s extraordinary economic gamble

Fiscal policy is adding to demand even as the economy is running hot

VOLATILITY is back. A long spell of calm, in which America’s stockmarket rose steadily without a big sell-off, ended abruptly this week. The catalyst was a report released on February 2nd showing that wage growth in America had accelerated. The S&P 500 fell by a bit that day, and by a lot on the next trading day. The Vix, an index that reflects how changeable investors expect equity markets to be, spiked from a sleepy 14 at the start of the month to an alarmed 37. In other parts of the world nerves frayed.

Markets later regained some of their composure. But more adrenalin-fuelled sessions lie ahead. That is because a transition is under way in which buoyant global growth causes inflation to replace stagnation as investors’ biggest fear. And that long-awaited shift is being complicated by an extraordinary gamble in the world’s biggest economy. Thanks to the recently enacted tax cuts, America is adding a hefty fiscal boost to juice up an expansion that is already mature.

Public borrowing is set to double to $1 trillion, or 5% of GDP, in the next fiscal year. What is more, the team that is steering this experiment, both in the White House and the Federal Reserve, is the most inexperienced in recent memory. Whether the outcome is boom or bust, it is going to be a wild ride.

Fire your engines

The recent equity-market gyrations by themselves give little cause for concern. The world economy remains in fine fettle, buoyed by a synchronised acceleration in America, Europe and Asia. The violence of the repricing was because of newfangled vehicles that had been caught out betting on low volatility. However, even as they scrambled to react to its re-emergence, the collateral damage to other markets, such as corporate bonds and foreign exchange, was limited.

Despite the plunge, American stock prices have fallen back only to where they were at the beginning of the year.

Yet this episode does signal just what may lie ahead. After years in which investors could rely on central banks for support, the safety net of extraordinarily loose monetary policy is slowly being dismantled. America’s Federal Reserve has raised interest rates five times already since late 2015 and is set to do so again next month. Ten-year Treasury-bond yields have risen from below 2.1% in September to 2.8%. Stockmarkets are in a tug-of-war between stronger profits, which warrant higher share prices, and higher bond yields, which depress the present value of those earnings and make eye-watering valuations harder to justify.

This tension is an inevitable part of the return of monetary policy to more normal conditions.

What is not inevitable is the scale of America’s impending fiscal bet. Economists reckon that Mr Trump’s tax reform, which lowers bills for firms and wealthy Americans—and to a lesser extent for ordinary workers—will jolt consumption and investment to boost growth by around 0.3% this year. And Congress is about to boost government spending, if a budget deal announced this week holds up. Democrats are to get more funds for child care and other goodies; hawks in both parties have won more money for the defence budget. Mr Trump, meanwhile, still wants his border wall and an infrastructure plan. The mood of fiscal insouciance in Washington, DC, is troubling. Add the extra spending to rising pension and health-care costs, and America is set to run deficits above 5% of GDP for the foreseeable future. Excluding the deep recessions of the early 1980s and 2008, the United States is being more profligate than at any time since 1945.

A cocktail of expensive stockmarkets, a maturing business cycle and fiscal largesse would test the mettle of the most experienced policymakers. Instead, American fiscal policy is being run by people who have bought into the mantra that deficits don’t matter. And the central bank has a brand new boss, Jerome Powell, who, unlike his recent predecessors, has no formal expertise in monetary policy.

Does Powell like fast cars?

What will determine how this gamble turns out? In the medium term, America will have to get to grips with its fiscal deficit. Otherwise interest rates will eventually soar, much as they did in the 1980s. But in the short term most hangs on Mr Powell, who must steer between two opposite dangers. One is that he is too doveish, backing away from the gradual (and fairly modest) tightening in the Fed’s current plans as a salve to jittery financial markets. In effect, he would be creating a “Powell put” which would in time lead to financial bubbles. The other danger is that the Fed tightens too much too fast because it fears the economy is overheating.

On balance, hasty tightening is the greater risk. New to his role, Mr Powell may be tempted to establish his inflation-fighting chops—and his independence from the White House—by pushing for higher rates faster. That would be a mistake, for three reasons.

First, it is far from clear that the economy is at full employment. Policymakers tend to consider those who have dropped out of the jobs market as lost to the economy for good. Yet many have been returning to work, and plenty more may yet follow (see article). Second, the risk of a sudden burst of inflation is limited. Wage growth has picked up only gradually in America.

There is little evidence of it in Germany and Japan, which also have low unemployment. The wage-bargaining arrangements behind the explosive wage-price spiral of the early 1970s are long gone. Third, there are sizeable benefits from letting the labour market tighten further.

Wages are growing fastest at the bottom of the earnings scale. That not only helps the blue-collar workers who have been hit disproportionately hard by technological change and globalisation. It also prompts firms to invest more in capital equipment, giving a boost to productivity growth.

To be clear, this newspaper would not advise a fiscal stimulus of the scale that America is undertaking. It is poorly designed and recklessly large. It will add to financial-market volatility.

But now that this experiment is under way, it is even more important that the Fed does not lose its head.

The end of an era for market tranquility

Wall Street suffered its worst week in years as investors grasped that the era of cheap money is set to disappear

Nicole Bullock, Eric Platt and Alexandra Scaggs

© FT montage; Getty Images

For more than a decade, Mike Schmanske made a living trading “volatility” — betting on the size and speed of moves in the US stock market. After 2014, the market was calm for so long that he spent much of his time sailing a Swan yacht. He got his adrenalin flowing in a different way: on his first trip from Bermuda to Newport, Rhode Island, he raced a hurricane back to port and made it with 12 hours to spare.

Now, a new bout of turbulence is pulling him back to Wall Street. A sharp outbreak of volatility has written more than $5tn off the value of global stocks in less than two weeks and Mr Schmanske is talking to his old trading buddies about getting back into the market.

“This is the most calls I’ve taken in years,” says Mr Schmanske*, a pioneer of some of the first volatility trading products while at Barclays and now a consultant. “Things were slow. I was literally on a boat a few weeks back.”

The catalyst for the volatility surge came at 8:30am last Friday when the US government employment report showed a surprisingly strong rise in wages, prompting bond yields to shoot upwards and the price of those bonds to fall. Within hours, the losses in the $14tn Treasury market had spread to stocks, setting the stage for Wall Street’s worst week in two years.** By Thursday, US equities had entered what is known as a correction — a fall of at least 10 per cent. Many investors who had piled into esoteric instruments that enable them to bet on continued calm in the market had been wiped out.

Benchmark Treasury yields approached 2.8 per cent

The ructions over the past week have attracted so much attention because they strike at the question that has haunted markets for the past two years — what happens when the economy returns to normal? Since the financial crisis, markets have been boosted by an unprecedented mixture of ultra-low interest rates and asset-buying by central banks in a bid to fend off the threat of deflation. But with global growth robust and inflation beginning to re-appear, central banks are pulling back.

The question investors are trying to answer is how much of the sharp drop in share prices is due to a technical reaction driven by a much-hyped niche in the market that bets on volatility, versus part of a broader adjustment to a different economic reality.

“The system has changed,” says Jean Ergas, head strategist at Tigress Partners, who said the market had made more of a “rethink” than a correction. “This is the unwinding of a massive carry trade, in which people borrowed at zero per cent and put money into stocks for a yield of 2 per cent.”

US stocks fell amid higher bond yields and rising wages

The year began on a euphoric note as a large cut in US corporate tax prompted investors to mark up their expectations for earnings growth. The economy was already humming around the world for the first time since the financial crisis.

At its peak on January 26, the market values of S&P 500 companies had surged by $5tn from a year earlier, while global stocks were up by nearly $14tn. The gains lured small investors into the market, with more than $350bn pumped into equity funds in the year, according to fund tracker EPFR Global.

But cracks had already appeared in the bond market. Investors were starting to make noise and demand higher yields. Bill Gross and Jeffrey Gundlach — two well-known money managers in fixed-income markets — both declared last month a new era after a 36-year “bull market” in bonds, which had seen yields driven steadily lower.

It was against that backdrop that markets reacted to last Friday’s news of a 2.9 per cent rise in US wages — not dramatic in a different era but still the largest year-on-year rise since the financial crisis. Inflation fears rose. Investors began marking up the odds that the Federal Reserve could tighten policy by a full percentage point this year, more aggressively than previously thought. Robust growth in Europe and Japan also raised the question of when the European Central Bank and Bank of Japan would begin to remove crisis-era stimulus.

Vix rocketed higher as volatility erupted on Wall Street

“Inflation fears running back into the market and hitting basically all assets in a market that had run up significantly is a pretty plausible, simple story,” says Clifford Asness, co-founder of AQR Capital Management. “You do not have to go looking for Alger Hiss in this pumpkin.”

By the end of last Friday, yields on benchmark 10-year US Treasuries had hurdled above 2.8 per cent for the first time in nearly four years. For the year, yields had risen more than 40 basis points, increasing the appeal of bonds relative to stocks. The Dow Jones Industrial Average lost 666 points — an unsettling omen for religiously minded traders.

“Optimism over synchronised global growth and supportive macro conditions led to outsized gains in equity markets to start the year,” says Craig Burelle, macro strategies research analyst at Loomis Sayles. “But more recently, some investors worried the economic momentum was too much of a good thing, and optimism gave way to concerns about the future path of inflation and interest rates.”

Before long, the anxiety had gone global. On Sunday evening, many Americans were watching the Philadelphia Eagles upset the New England Patriots in the Super Bowl: at the same time, Asian markets were opening on Monday with a spike in bond yields.

“On any other Sunday night you might have been more anxious about what you were seeing,” says Matt Cheslock, a trader at Virtu and a 25-year veteran of the New York Stock Exchange. “The game provided a nice distraction.”

Inverse Vix ETN killed off after imploding

Monday morning in the US added a new source of uncertainty with the swearing in of Jay Powell as the chairman of the Federal Reserve, bringing a relatively little-known face to lead the central bank. For much of the day, Wall Street avoided serious losses. Then, a big drop seemed to come out of nowhere. About an hour before the closing bell, the Dow slumped more than 800 points in 10 minutes.

“The adrenalin kicks in,” says Mr Cheslock. “Everyone gets sharper. The complacency is long gone.”

Customers rushed to log into their accounts at Vanguard, TD Ameritrade, T Rowe Price and Charles Schwab, straining websites. Some were unable to place orders.

“As the volatility picks up and the indices plummet the rumours start to swell,” says Michael Arone, chief investment strategist at State Street Global Advisors. “Folks are wondering the classic Warren Buffett line about when the tide goes out, you see who is not wearing swimming trunks.”

Over the past week, the investors who have been left most exposed are those who had made bets on subdued volatility. As share prices slumped, Wall Street’s “fear gauge” — the widely watched Cboe Vix volatility index — spiked.

Trading strategies that profited from the calm in markets during 2017 quickly unravelled. Two exchange-traded products that enabled investors to bet on low volatility lost nearly all their value on Monday.

After the bell on Monday, the Vix continued to rise and shares in vehicles related to Vix also fell.

On Tuesday morning, Nomura, the Japanese bank, said in Tokyo that it would pull a product that was pegged to S&P 500 volatility. Within half an hour, the Nikkei 225 had fallen 2.5 per cent, which, in turn, prompted a bout of selling in bitcoin. The digital currency — worth more than $19,000 as recently as December — dropped below $6,000 just after 2:45am in New York, as traders in London and Frankfurt were getting to their desks. Stock markets in both countries would open 3.5 per cent lower.

As US investors slept, the turbulence continued. At 4am in New York, a number of exchange traded products related to volatility were halted. By 7:11am, more than two hours before the US open, the Vix volatility index shot above 50 — only the second time it has done so since 2010. The turbulence forced bankers to postpone a number of bond sales planned for the day.

Then Credit Suisse said it would close an exchange traded note, known by the ticker XIV — which is designed to move in the exact opposite direction to the Vix each day, and had thus collapsed as volatility rose.

US equity trading volumes hit record high as markets convulsed

“People had forgotten that stocks don’t just go up,” says Adam Sender, head of Sender Company and Partners, a hedge fund. “Corrections are a normal process. This was inevitable. Interest rates rising was the trigger, but short-volatility was the fuel.”

The volatility subsided amid a Tuesday afternoon rally in New York, and world stock markets survived much of the next day without incident. But then at 1pm on Wednesday in New York, signs of nervousness re-emerged. Demand at the auction of US Treasury bonds was weak, a signal that investors were worried about inflation and a rising budget deficit, and would therefore only buy at higher yields. Stocks ended the day in the red, and when investors in Tokyo returned on Thursday, prices dropped quickly. Heavier selling ensued on Wall Street.

By Friday morning, the main indices in the US, Germany and Japan were all down more than 10 per cent from their January highs. When trading finally closed for the week after another rollercoaster day, US losses were shaved to about 9 per cent.

For some, the shock created by the collapse of the volatility products has been salutary. “It’s always good to be reminded of these things with accidents that aren’t of systemic importance to the entire economy,” says Victor Haghani, founder of London’s Elm Partners and an alumnus of Long-Term Capital Management. “It’s a gentle reminder from the market.”

However, many investors believe the questions raised over the past week go well beyond the products connected to the Vix index. “We’ve gone from a market used to playing checkers — rising earnings, low rates equals higher prices — to being forced to compete in grandmaster three-dimensional chess: worries over growth versus rates, equity valuations, and the strength of the dollar, and now market structure concerns,” says Nicholas Colas, cofounder of DataTrek, a New York research group.

Global equities suffered record weekly outflows

While some investors talked of a buying opportunity, believing that faster economic growth and a modest uptick in inflation represent a positive backdrop for equities, many headed for the exits. Investors pulled more than $30bn from stock funds in the week to Wednesday, the largest week of withdrawals since EPFR began tracking the data at the turn of the century.

The slump in share prices put the White House on the defensive, given that President Donald Trump has taken pride in the stock gains under his administration. “In the ‘old days,’ when good news was reported, the Stock Market would go up. Today, when good news is reported, the Stock Market goes down,” he tweeted on Wednesday. “Big mistake, and we have so much good (great) news about the economy!”

Others were less confident. “This is not yet a major earthquake,” said Lawrence Summers, US Treasury secretary under President Bill Clinton. “Whether it’s an early tremor or a random fluctuation remains to be seen. I’m nervous and will stay nervous. [It is] far from clear that good growth and stable finance are compatible.”

Some strategists expect the recent declines to lead to further selling, as computer-driven funds that target volatility are forced to shed more equities. Analysts put the amount of automatic selling from the recent turmoil at about $200bn, and more could be on the way unless markets simmer down.

Jonathan Lavine, co-managing partner of Bain Capital, says a drop in share prices was not a surprise in itself. “It was the ferocity of the move, not triggered by any material news and propelled by a small corner of financial markets,” he says. “You have to ask yourself what would happen in the event of real bad news.”

Additional reporting by John Authers, Joe Rennison and Robin Wigglesworth

China’s Irresistible Rise

Jim O'Neill

A woman uses an escalator in a shopping mall in Shanghai

LONDON – China’s recently released GDP data for 2017 confirm it: the country’s dramatic rise, with the concomitant increase in its global economic relevance, is not slowing down.

To be sure, there has been fresh media chatter about the reliability of Chinese data, owing to reports that some provinces have been overestimating their economic performance in recent years. But for all we know, other provinces may have been doing the opposite. And in any case, the provinces that have admitted to inflating their data are not large enough to have a significant impact on the national picture.

Moreover, two key points are often lost in the debate about China’s official statistics, which the country first starting releasing in the late 1990s. First, the debate is relevant only if China is increasing the degree to which it overestimates its data. Second, China’s published data should be considered in the context of its trading partners’ own figures, as well as those of major international companies that do business in China. As I have written before, it is telling that China has overtaken both France and the United States to become Germany’s top trading partner.

As for the annualized 2017 data, most of the media focus has been on China’s reported real (inflation-adjusted) GDP growth, which, at 6.9%, represents the first acceleration in a couple of years and an improvement even on the government’s soft target rate of 6.5%. But the more important figure is China’s nominal GDP growth translated into US dollars. Owing partly to a strengthening renminbi, China’s total economic output grew to $12.7 trillion in 2017, representing a massive increase of 13% ($1.5 trillion) in just 12 months.

Clearly, those who have warned that China is following in Japan’s footsteps and heading for a long-term deflationary cycle have been far off the mark. To my mind, such simplistic comparisons are never particularly useful. Not only has China averted the risk of deflation; it has done so with an appreciating currency.

When my former Goldman Sachs colleagues and I first started tracking the rise of the BRIC economies (Brazil, Russia, India, and China) in the early 2000s, we figured that it would take until the end of 2015 just for China to catch up to Japan. Yet 2018 has barely started, and already China’s economy is two-and-a-half times larger than Japan’s, five times larger than India’s, six times larger than Brazil’s, and eight times larger than Russia’s. It is also larger than the entire eurozone.

China’s staggering $1.5 trillion expansion in 2017 means that, in nominal terms, it essentially created a new economy the size of South Korea, twice the size of Switzerland, and three times the size of Sweden. The latest data suggest that China could catch up to the US, in nominal terms, sometime around 2027, if not before. Within a decade after that, the BRIC countries collectively could catch up to the G7 economies.

Of course, such an achievement would be driven largely by China. Still, taken together, the remaining BRICs are larger than Japan. And now that Brazil and Russia have put their recent recessions behind them, the BRICs will likely make a large contribution to nominal global GDP in 2018.

One final consideration for the global growth outlook is the Chinese consumer. Many commentators still discuss China as if it were solely an industrial power. But consumption in China has crept up nearly to 40% of GDP. Since 2010, Chinese consumers have added around $2.9 trillion to the world economy. That is bigger than the United Kingdom’s entire economy. British trade negotiators should take note: after Brexit, the Chinese market will be more important to the UK economy than ever.

Yet, in addition to its annualized data, China also recently reported its December data, which revealed monthly reported-retail-sales growth of a slightly disappointing 9.4% year on year. One hopes that this is a reflection not of a consumption slowdown, but rather of Chinese policymakers tightening financial conditions in the second half of 2017.

Needless to say, as China becomes increasingly important to the global economy, its upside and downside risks will continue to have far-reaching implications for the rest of the world. And, indeed, a consumption slowdown would be bad not just for China, but also for the rest of the world economy, which is now depending on China’s shift from industrial production to domestic consumption.

Jim O'Neill, a former chairman of Goldman Sachs Asset Management and former Commercial Secretary to the UK Treasury, is Honorary Professor of Economics at Manchester University and former Chairman of the Review on Antimicrobial Resistance.

Lex in Depth: the case against share buybacks

With investment in development stuck at pre-crisis levels and stock prices high, do US companies’ huge repurchases make sense?

Dan McCrum in London

© FT montage

S&P 500 companies have spent $1.1tn on share repurchase programmes over the past two years, as executives struggled to turn modest economic growth into higher earnings. Lacking opportunities to invest, or at least shareholder support to do so, companies have spent money buying their own stock, which provides a boost to the size of profits reported per share.

Fresh records for buybacks are likely to be set, with changes to the US tax regime expected to trigger a repatriation of profits that have been held offshore for years.

A string of companies, including Boeing and Honeywell, have announced close to $90bn worth of share buyback programmes since the reforms were agreed in December. Bank of America Merrill Lynch estimates that of $1.2tn parked overseas, perhaps half of the post-tax total, or around $450bn, could be devoted to share buybacks.

“Shareholders are going to be banging on doors saying we want some of that money,” says Howard Silverblatt, senior index analyst at S&P Dow Jones. No matter that stock markets have set record highs of late, the expectation that spare cash must be returned to its rightful owners is putting managers under pressure.

lex in depth chart

“They almost have to buy when the stock is high. Timing the market is not something most companies can do,” adds Mr Silverblatt. But the new flood of dollars raises an old question about whose interest the practice serves.

Companies justify buybacks in terms of discipline and confidence. But, almost nine years into a stock market boom, executives are planning to buy shares when long-term valuations have rarely been higher. The latest surge comes as many companies have already piled up cheap debt simply to fund payouts to shareholders.

Meanwhile, the proportion of sales spent on research and development at S&P 500 companies is still yet to recover to pre-2008 levels. William Lazonick, professor of economics at University of Massachusetts Lowell, is a critic of what he calls “profits without prosperity”. Blaming the financialisation of business, he sees in the mantra of shareholder returns the neglect of investment over short-term profits.

With Federal Reserve chair Janet Yellen beginning to raise rates last year, debt fuelled repurchases could become riskier © Reuters

“The only benefit of share buybacks is to people who are in the business of selling shares: executives,” he says.

Do buybacks undermine the financial health of companies, juice bonuses and threaten the real economy? Lex examines the charge sheet.

Charge 1

Staff benefit more than shareholders

Companies are run on behalf of a diverse range of investors often with competing interests.

Calls for buybacks can sometimes be seen as a response to a lack of trust from some investors that managers will spend the cash wisely.

“The positive view mostly comes from a period when many companies were sitting on too much cash, and investors intended [the buyback] as a way to impose discipline,” says Fabrizio Ferri, associate professor at the Columbia Business School. Corporate raiders such as Carl Icahn, who rose to fame in the 1980s by breaking up flabby conglomerates for profit, evolved into activist investors preaching a mantra of shareholder returns.

lex in depth chart

Today, the announcement of a buyback can be a signal that shares are cheap, or a response to discontent with profits or strategy. Before General Electric announced a cut in its dividend last year, for only the second time since the depression, the manufacturing conglomerate was part way through a $50bn programme of repurchases announced while under pressure from the activist investor Nelson Peltz.

For many companies, particularly those in the technology sector, routine buybacks are a consequence of rising share prices. “The connection between stock compensation for employees and buybacks is very real,” says David Zion, founder of Zion Research. Staff sell stock awards, forcing companies to buy to keep the share count stable. Apple has admitted that a primary purpose of its buybacks is to neutralise the impact of stock compensation.

The company has spent $151bn on repurchasing stock in the past decade, about 17 per cent of its almost $900bn market valuation. The number of shares has dropped by about the same amount — 17 per cent. Yet when Apple started to buy in 2012, the shares could be bought for half today’s price. The difference has been handed to employees.

Verdict Guilty.

Charge 2

Opportunity for manipulation

Unlike a dividend paid at regular intervals, executives usually have authority to buy back stock at their own discretion. For most of the last century boards were reluctant to grant it because a company that dipped into the market to buy its own stock would arouse suspicion of market manipulation.

In 1982, however, the US Securities and Exchange Commission outlined a legal “safe harbour” for buybacks. Their popularity soared in the 1990s, as companies began rewarding executives with stock options. The value of such grants is tied to the share price, with dividend payments doing little or nothing for a chief executive’s remuneration.

In 1998 the value of buybacks by S&P 500 members topped that of dividends for the first time.

The pattern has been repeated in 13 of the past 14 years.

Purchases can be used to shrink the number of shares in issue when earnings per share needs a boost, or to support the price when employees are exercising options to sell stock. Little disclosure about the precise timing of buybacks is required, and the area is not one where the SEC, which polices accounting issues, has typically taken action.

lex in depth chart

But the manipulation charge tends to fall flat because investors can see what is spent each quarter, and track movements in the number of shares in issue. They also tend to have an interest in a higher share price, and reward companies whose profits are predictable.

For instance, between 2005 and 2007 GE was one of the largest acquirers of its own stock, spending $32bn. When the financial crisis hit in 2008, the company was forced to raise $15bn from investors, leading to criticism that the repurchases were not the best use of capital. Yet shareholders had cheered the activity at the time.

Equilar, which benchmarks corporate compensation, says that just over half of US listed companies use a total shareholder return metric, which adds dividends to share price gains, when setting executive pay.Only about a third of boards use EPS to determine pay awards.

“Companies realise that buybacks have an effect on EPS,” says Dan Marcec of Equilar. “When a company buys back shares at the same time it is using EPS as a performance metric, it will almost always have a way of adjusting for that effect”.

Verdict Not guilty. Blame the investors, board and disclosure rules if some managers manipulate EPS.

Charge 3

Executives can be a bad judge of value

The only year in the past 14 when big US companies spent less on buybacks than dividends was 2009, when the S&P 500 index hit rock bottom. “The best time to do [a buyback] is in a recession, but that’s when everyone is scared stupid,” says Andrew Lapthorne, a quantitative strategist for Société Générale.

If a company has more cash than it needs, and nothing better to invest in, it should consider whether buying its own stock is a good investment. Yet the time when companies have plenty of spare cash tends to be when business is good and shares are overvalued.

lex in depth chart

Many companies bought back shares before money became tight. Commodity trader Glencore announced a $1bn buyback in 2014, but a year later it cancelled the dividend and raised equity as it scrambled to cut debt after commodity prices crashed.

But it is hard for executives to hold on to cash in anticipation of a distant downturn, or to argue that their shares are overpriced. Few companies are ever explicit about the thinking or calculation that determines when it makes sense to repurchase.

Warren Buffett’s Berkshire Hathaway is an exception. The conglomerate of insurers and industrial companies does not pay a dividend, and rarely repurchases shares. Mr Buffett has said he will buy them only when the stock is undervalued, defined as less than 1.2 times the stated book value of its assets, something that has not occurred in years.

Verdict Guilty.

Charge 4

Buybacks reduce real investment

Some companies have managed to spend more on buybacks in recent years than the shares are worth today.

Since 1995 IBM, the consulting and supercomputer group, has spent $162bn to repurchase more than half of its outstanding shares. What is left, for those who did not sell, is a company now valued at $154bn, suggesting the money was spent in the wrong place.

lex in depth chart

Any company will wonder what its valuation might have been, were different decisions taken. Prof Lazonick points to the example of Cisco Systems, the world’s largest networking company. In two decades it has spent $75bn repurchasing stock, more than three times the total for capital investment in property or equipment. A serial acquirer of other businesses, it has long struggled to grow sales.

Prof Lazonick suggests a dramatic alternative reality for the company, pointing to an employee-owned business that has taken much of the market for the infrastructure underpinning mobile phone networks. He says: “There’s the company that Cisco should have been, or could have been, and it’s the Chinese company, Huawei”.

Verdict The jury is out.

Charge 5

Encouraging fragility

Three of the most dangerous words in the English language are “debt is cheap”. Low interest rates have encouraged corporate borrowing to buy back stock and boost earnings per share.

“Traditionalists would say equity is expensive and not tax efficient. Debt is cheap and tax-deductible. The problem with that argument is it completely misunderstands credit risk,” says Mr Lapthorne.

The beauty of equity as a source of capital for business is that as it is perpetual, it does not need to be repaid. In a credit crunch or downturn, dividends can be cut to save cash, fresh equity sold.

lex in depth chart

Yet the popularity of buybacks has changed the cycle, for listed companies at least. Before the 2008 financial crisis, measures of indebtedness, or so-called leverage, fell. Overall debt levels were rising, but asset values were also much inflated. For non-financial companies in the S&P 1500, net debt as a proportion of assets dropped from 21 per cent in 2000, to below 9 per cent five years later. This time the metric has steadily risen along with the market, to exceed 19 per cent.

Last April the International Monetary Fund calculated that $7.8tn had been added to the liabilities of US companies since 2010. Median net debt of S&P 500 companies was close to a record high of 1.5 times earnings. Contemplating Federal Reserve plans to raise interest rates, the IMF last year warned that businesses representing a fifth of corporate assets could struggle to meet higher interest costs.

Verdict Guilty as hell.

General Electric last year reduced its dividend, only its second cut since 1939, while a $50bn buyback programme was under way © Bloomberg

Summing up/sentencing

Guilty on three out of five charges, executives who propose to spend money on expensive shares will be condemned to the enduring suspicion of shareholders. Early parole will be granted for good behaviour, including clear articulation of how a company approaches the decision to buy its own stock, and for investment in the real economy.

Additional reporting by Tom Braithwaite in San Francisco

Man and machine

Autonomous weapons are a game-changer

AI-empowered robots pose entirely new dangers, possibly of an existential kind

MANY OF THE trends in warfare that this special report has identified, although worrying, are at least within human experience. Great-power competition may be making a comeback.

The attempt of revisionist powers to achieve their ends by using hybrid warfare in the grey zone is taking new forms. But there is nothing new about big countries bending smaller neighbours to their will without invading them. The prospect of nascent technologies contributing to instability between nuclear-armed adversaries is not reassuring, but past arms-control agreements suggest possible ways of reducing the risk of escalation.

The fast-approaching revolution in military robotics is in a different league. It poses daunting ethical, legal, policy and practical problems, potentially creating dangers of an entirely new and, some think, existential kind. Concern has been growing for some time. Discussions about lethal autonomous weapons (LAWs) have been held at the UN’s Convention on Certain Conventional Weapons (CCW), which prohibits or restricts some weapons deemed to cause unjustifiable suffering. A meeting of the CCW in November brought together a group of government experts and NGOs from the Campaign to Stop Killer Robots, which wants a legally binding international treaty banning LAWs, just as cluster munitions, landmines and blinding lasers have been banned in the past.

“Most people agree that when lethal force is used, humans should be involved. But what sort of human control is appropriate?

The trouble is that autonomous weapons range all the way from missiles capable of selective targeting to learning machines with the cognitive skills to decide whom, when and how to fight.

Most people agree that when lethal force is used, humans should be involved in initiating it. But determining what sort of human control might be appropriate is trickier, and the technology is moving so fast that it is leaving international diplomacy behind.

To complicate matters, the most dramatic advances in AI and autonomous machines are being made by private firms with commercial motives. Even if agreement on banning military robots could be reached, the technology enabling autonomous weapons will be both pervasive and easily transferable.

Moreover, governments have a duty to keep their citizens secure. Concluding that they can manage quite well without chemical weapons or cluster bombs is one thing. Allowing potential adversaries a monopoly on technologies that could enable them to launch a crushing attack because some campaign groups have raised concerns is quite another.

As Peter Singer notes, the AI arms race is propelled by unstoppable forces: geopolitical competition, science pushing at the frontiers of knowledge, and profit-seeking technology businesses. So the question is whether and how some of its more disturbing aspects can be constrained. At its simplest, most people are appalled by the idea of thinking machines being allowed to make their own choices about killing human beings. And although the ultimate nightmare of a robot uprising in which machines take a genocidal dislike to the human race is still science fiction, other fears have substance.

Nightmare scenarios

Paul Scharre is concerned that autonomous systems might malfunction, perhaps because of badly written code or because of a cyber attack by an adversary. That could cause fratricidal attacks on their own side’s human forces or escalation so rapid that humans would not be able to respond. Testing autonomous weapons for reliability is tricky. Thinking machines may do things in ways that their human controllers never envisaged.

Much of the discussion about “teaming” with robotic systems revolves around humans’ place in the “observe, orient, decide, act” (OODA) decision-making loop. The operator of a remotely piloted armed Reaper drone is in the OODA loop because he decides where it goes and what it does when it gets there. An on-the-loop system, by contrast, will carry out most of its mission without a human operator, but a human can intercede at any time, for example by aborting the mission if the target has changed.

A fully autonomous system, in which the human operator merely presses the start button, has responsibility for carrying through every part of the mission, including target selection, so it is off the loop. An on-the-loop driver of an autonomous car would let it do most of the work but would be ready to resume control should the need arise. Yet if the car merely had its destination chosen by the user and travelled there without any further intervention, the human would be off the loop.

For now, Western armed forces are determined to keep humans either in or on the loop. In 2012 the Pentagon issued a policy directive: “These [autonomous] systems shall be designed to allow commanders and operators to exercise appropriate levels of human judgment over the use of force. Persons who authorise the use of, direct the use of, or operate, these systems must do so with appropriate care and in accordance with the law of war, applicable treaties, weapons-systems safety rules and applicable rules of engagement.”

That remains the policy. But James Miller, the former under-secretary of Defence for Policy at the Pentagon, says that although America will try to keep a human in or on the loop, adversaries may not. They might, for example, decide on pre-delegated decision-making at hyper-speed if their command-and-control nodes are attacked. Russia is believed to operate a “dead hand” that will automatically launch its nuclear missiles if its seismic, light, radioactivity and pressure sensors detect a nuclear attack.

Mr Miller thinks that if autonomous systems are operating in highly contested space, the temptation to let the machine take over will become overwhelming: “Someone will cross the line of sensibility and morality.” And when they do, others will surely follow. Nothing is more certain about the future of warfare than that technological possibilities will always shape the struggle for advantage.

For Iran, Tough Choices Ahead

By Xander Snyder

The protests that broke out throughout Iran late last month have dissipated and, it seems, things have largely returned to normal. But while the regime was able to put down the unrest, it has been unable to address its underlying causes, which are being exacerbated by a combination of domestic economic problems and internal and regional security concerns. The lack of economic opportunities, combined with frustration over the regime’s continued spending on its own defense and foreign interventions in places such as Syria, Lebanon and Yemen, set off the demonstrations that continued into the new year. Now the regime has a choice to make: Increase spending on domestic economic initiatives that address the concerns of the population, or maintain the strength – and loyalty – of the security apparatus that ensures the regime’s very survival. Both options come with drawbacks, none of which the regime can take lightly.
Changes Coming
The regime in Iran has a history of suppressing protests and making small concessions to try to relieve the pressure caused by the demonstrations. Its response to the most recent protests is no different. A leaked version of the 2018 budget sparked anger in December over funding for the Islamic Revolutionary Guard Corps and cuts to public subsidies. (Ninety-five percent of Iranians receive such subsidies.) The regime has thus made changes to the budget, and they appear to address some of the concerns: the planned cuts to cash subsidies will now target higher income earners; a hike in fuel prices that was in the initial budget has been eliminated; and the government will set aside $3.3 billion to cover 2 million to 3 million depositors affected by unregulated credit institutions.
But Ayatollah Ali Khamenei also allocated $2.5 billion of the country’s National Development Fund – which was estimated to have $68 billion in assets in 2016 – for additional defense spending. Why would Iran continue to increase defense spending if it was the perception of a privileged IRGC – an institution that got more funding while subsidies for average Iranians were slashed – that set off the protests in the first place? The short answer is Iran has no other option. It’s facing increasing security risks both at home and abroad, and it can’t afford to let its security institutions go underfunded.
Further complicating the situation are the divisions within the regime itself that are being exacerbated by the increasingly apparent socio-economic problems. To increase his own support base, President Hassan Rouhani is using the recent protests as evidence that the policies of the clerical elites, the main backers and beneficiaries of the IRGC, have failed. Khamenei, who is part of the clerical establishment, has cautiously acknowledged the concerns of the protesters but remains focused on strengthening and funding the IRGC to ensure its loyalty lies with the clerics.
At the same time, Khamenei instructed the IRGC last week to divest large portions of its business interests, which represent a substantial portion of the Iranian economy – 30 percent by some estimates. The IRGC became increasingly involved in the management of the Iranian economy following the Iran-Iraq war, when critical infrastructure needed to be rebuilt. Khamenei’s reasoning for wanting the IRGC to withdraw from the economy is two-fold: First, it attempts to address some of the protesters’ concerns by decreasing the IRGC’s economic power, but without actually defunding it. Second, and more important, privatization is seen as a step toward increasing transparency and, therefore, attracting more foreign investment, which remains at risk due to uncertainty over U.S. commitment to the nuclear deal. Either way, divestment could create even more internal divisions, both between the clerics and the IRGC and also within the IRGC itself, because the organization’s leadership is split on whether to support the move.
Iran’s Syria Problem
The external pressures on Iran come from various sources but meet in one location: Syria. President Bashar Assad, an Iranian ally, is facing new challenges in western Syria. Turkey has invaded the northwestern Afrin region, and given the size of the Turkish force, its technological superiority and the relatively small number of Kurdish defenders, it seems likely that Turkey will take control of it.

And with that, Turkey will have essentially surrounded Aleppo, Syria’s largest city, on three sides. Turkish President Recep Tayyip Erdogan has also threatened to move on the city of Manbij, east of Aleppo, and if he were to follow through on this threat – which we haven’t seen any signs of yet and which is unlikely because the U.S. still supports the Kurds in this region – Turkey would essentially have encircled Aleppo.

But even if it doesn’t make a move on Manbij, surrounding most of Aleppo with Turkish forces would present a major threat to both Assad and Iran. Iran has to consider the risks that a resurgent Turkey would pose to it and will therefore be highly motivated to keep its proxies in Syria and Iraq. Containing Turkey to northwestern Syria is cheaper and safer than trying to fight off Turkish troops in eastern Syria, assuming that they’re able to advance that far. But if Turkish-backed Sunni Arab forces can take control of eastern Syria – the areas that IS used to dominate – then the Iranian position in Iraq becomes vulnerable. A coalition of Sunni groups in eastern Syria can support the Sunni minority in western Iraq, which would be a threat to the Shiite-dominated regime in Baghdad. Given Russia’s at least tacit cooperation with Turkey in Afrin – allowing it to use Syrian airspace to bombard Kurdish defensive positions – Iran knows that it can’t depend on Russia to achieve its security objectives. (In fact, a recent article in Daily Kayhan, a conservative Iranian paper, discussed Russia’s and Iran’s diverging interests in Syria.) The burden will fall on Iran to help Assad defend Aleppo, and that will come at a cost.
Closer to home, the IRGC clashed with 21 Islamic State militants in western Iran on Jan. 27. Iran believes that the fighters emerged from hiding in Kurdish-held areas of Syria, although it doesn’t seem to believe that the Kurds were assisting the militants. The Islamic State has lost most of its territory in Syria, but that doesn’t mean IS fighters have all left the country – they have simply blended into the local population. This was a small skirmish – although three Iranian soldiers were killed – and the IRGC was able to defeat the militants. IS suicide bombers and gunmen attacked Tehran in June, but this was the first time an organized IS militia has attacked Iran, driving home the fact that Iran is still at risk within its borders. The growing IS presence in Afghanistan, a country that shares a border with Iran, is also a concern.
While Iran has emerged from the Syrian civil war in a strong position relative to its regional adversaries, its social and political stability has been shaken.    

Eventually, Iran will be forced to make a choice, and this will limit its foreign adventures just as Turkey, its longtime nemesis, increases its power and its involvement in Syria, presenting an ever greater challenge to Tehran.