Pre­pare for hur­ri­canes

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Af­ter months of con­tented lethargy, Fri­day’s big sell-off seemed to con­firm the main points that Louis Gave and I made in our con­fer­ence call two days ear­lier. Firstly, the faith in “lower for­ever” bond yields is not a rea­son for re­as­sur­ance, but a cause for con­cern. Se­condly, po­lit­i­cal risks have not been elim­i­nated by the sum­mer’s mar­ket rally, merely ig­nored. Thirdly, what I call the “fi­nan­cial hur­ri­cane sea­son” usu­ally starts in early au­tumn — and this year’s hur­ri­cane sea­son could be par­tic­u­larly scary, with a vi­cious US elec­tion less than two months away and as­set prices near record lev­els, while volatil­ity has fallen to near record lows.

Of course, fi­nan­cial crashes do not oc­cur every au­tumn and plenty of crises have oc­curred at other times of the year. But cen­turies of Wall Street sta­tis­tics show Septem­ber to be the only month with neg­a­tive stock per­for­mance on av­er­age. This sea­son­al­ity has a plau­si­ble ex­pla­na­tion. Dur­ing the sum­mer hol­i­days, when trad­ing is light, peo­ple tend to de­fer big de­ci­sions. The re­turn to work con­cen­trates minds, and the re­sult is of­ten a dras­tic mar­ket re-pric­ing to re­flect events that were not suf­fi­ciently rec­og­nized or an­a­lysed dur­ing the sum­mer months. Un­like the Caribbean, the world econ­omy does not ex­pe­ri­ence hur­ri­canes every au­tumn. But when ma­jor un­ex­pected events have hap­pened over the sum­mer, an au­tumn cri­sis of some kind be­comes quite a likely bet.

This year’s sur­prise sum­mer rally was driven by four sus­pect fac­tors: eco­nomic data, ex­pec­ta­tions of dovish mon­e­tary pol­icy, mo­men­tum, and op­ti­mism over po­lit­i­cal risk. Each of these forces now ap­pears to be re­vers­ing:

The most im­por­tant fac­tor dic­tat­ing the di­rec­tion of global mar­kets was, as usual, US eco­nomic data. Look­ing back on the past two months’ trad­ing, it is clear that the main cat­a­lyst for the sum­mer rally was the US pay­roll re­port on July 8. This pro­pelled the S&P 500 to a new record high the very next trad­ing day and that, in turn, meant Wall Street broke out from a year-long trad­ing range. This break-out sucked in pas­sive cash parked on the side lines — and all other risk as­sets im­me­di­ately ral­lied. So did the post-Brexit pound, with both GBP/USD and EUR/GBP en­joy­ing their big­gest re­bound on July 13, the day af­ter the S&P 500 broke out of its trad­ing range. So, the mar­ket re­bound post-Brexit had very lit­tle to do with good news from Bri­tain. A sin­gle month of strong US pay­rolls was enough to dis­tract in­vestors from Brexit and make them for­get the dam­age that break­ing up the sin­gle mar­ket could do to Europe in the years ahead. This kind of my­opic ex­trap­o­la­tion is fully con­sis­tent with mar­ket be­hav­ior since the 2008 cri­sis. For more than six years now, month-tomonth fluc­tu­a­tions in US pay­rolls have es­sen­tially dic­tated the short-term di­rec­tion of risk-on/risk-off trades all over the world. What­ever hap­pens in the rest of the world econ­omy, the suc­cess or fail­ure of US pol­icy is still seen as a lead­ing in­di­ca­tor of prospects for all other re­gions, since al­most every coun­try is fol­low­ing US-style poli­cies, but with long and vari­able lags. This sum­mer, such Pavlo­vian be­hav­ior seems again to have been the main force be­hind the rally — and that means the weak pay­roll re­port of Septem­ber 2 could on its own be suf­fi­cient to re­verse the bullish trend.

1) Eco­nomic data.

2)

4)

Mon­e­tary

Po­lit­i­cal

ex­pec­ta­tions.

What makes the cur­rent sit­u­a­tion even more dan­ger­ous is that mon­e­tary ex­pec­ta­tions dur­ing the sum­mer moved in the op­po­site di­rec­tion to eco­nomic data. Af­ter the Brexit ref­er­en­dum, any risk of US mon­e­tary tight­en­ing seemed to be per­ma­nently in abeyance and ru­mours abounded of fis­cal stim­u­lus in Ja­pan, Bri­tain and the eu­ro­zone. Once fears of a post-ref­er­en­dum fi­nan­cial cri­sis sub­sided, pol­i­cy­mak­ers be­gan to con­tra­dict all this spec­u­la­tion about fur­ther stim­u­lus. But mar­kets chose to ig­nore the pol­icy warn­ings, partly be­cause mo­men­tum in­vestors and trend-fol­low­ing al­go­rithms were chas­ing trends that had caught them short. This bullish mo­men­tum is now largely ex­hausted.

3) Mar­ket re­flex­iv­ity.

Thin sum­mer mar­kets dom­i­nated by trend-fol­low­ing al­go­rithms are not pre­dic­tive, but re­ac­tive. Black boxes do not act as the for­ward-look­ing price dis­cov­ery mech­a­nisms as­sumed in fi­nan­cial the­ory. In­stead of try­ing to un­der­stand and dis­count the fu­ture, al­go­rithms ex­trap­o­late the re­cent past. Pas­sive and sys­tem­atic in­vest­ment strate­gies there­fore am­plify re­flex­ive in­ter­ac­tions be­tween mar­ket ex­pec­ta­tions and eco­nomic re­al­ity, es­pe­cially in the short term. For ex­am­ple, the fact that stock mar­kets and cur­ren­cies sta­bilised in the two months af­ter the Bri­tish ref­er­en­dum en­cour­aged the Bri­tish govern­ment and vot­ers to be­lieve the dan­gers of Brexit were over­stated. That con­fi­dence, in turn, led to a re­bound in short term in­di­ca­tors of con­sumer and busi­ness sen­ti­ment. In re­al­ity, how­ever, the be­hav­iour of fi­nan­cial mar­kets in the weeks af­ter the ref­er­en­dum tells us noth­ing about the im­pact on Bri­tain of ex­clu­sion from the EU sin­gle mar­ket in the years and decades ahead. All of which leads, fi­nally, to the main rea­son for worry about this year’s fi­nan­cial hur­ri­cane sea­son.

com­pla­cency.

This sum­mer’s in­ter­ac­tion be­tween pol­i­tics and mar­ket be­hav­ior of­fers a case study in how re­flex­iv­ity can create fi­nan­cial booms and busts. In the first phase, which lasted for about two weeks af­ter the ref­er­en­dum, fears of mar­ket panic en­cour­aged pol­i­cy­mak­ers to sig­nal mon­e­tary eas­ing and hint at fis­cal stim­u­lus.

These pol­icy sig­nals changed re­al­ity by con­vinc­ing con­sumers and busi­nesses that there would be no postBrexit bust. The re­bound in con­fi­dence then pro­duced a se­cond phase, from early July to late Au­gust, when bullish mar­ket be­hav­ior cre­ated the im­pres­sion that po­lit­i­cal risks from the US pres­i­den­tial elec­tion and the forth­com­ing votes in Italy, the Nether­lands, France and Ger­many were all over­done. While the Brexit vote could have been seen as a lead­ing in­di­ca­tor of even more alarm­ing pop­ulist re­volts in the US and Europe pow­ered by sim­i­lar de­mo­graphic, so­cial and cul­tural forces, the bullish be­hav­ior of mar­kets seemed to sup­port the op­po­site con­clu­sion. Im­plied volatil­i­ties through Novem­ber 8 are still near record lows, de­spite the shock of Brexit — or per­haps be­cause of it. Most in­vestors seem to be­lieve that a Trump pres­i­dency is not worth wor­ry­ing about, be­cause the post-Brexit rally has proved that “anti-elit­ist” pol­i­tics are ac­tu­ally good for fi­nan­cial mar­kets or that po­lit­i­cal shocks can­not dis­rupt a liq­uid­ity-driven bullish trend. So the Brexit vote has ac­tu­ally made in­vestors more com­pla­cent about pop­ulist pol­i­tics be­cause the mar­ket re­ac­tion has been so be­nign. This in­vestor com­pla­cency has, in turn, made pop­ulist and pro­tec­tion­ist rhetoric sound much less threat­en­ing, thereby mak­ing it eas­ier for Trump to win.

But sen­ti­ment now seems to be shift­ing from con­fi­dence back to­wards fear. The cat­a­lyst for a se­ri­ous mar­ket cor­rec­tion may be weak US data, start­ing with Au­gust’s dis­ap­point­ing pay­rolls and con­tin­u­ing with the dis­mal ISM fig­ures last week. More im­por­tant, at least in my view, is any re­assess­ment of the US mon­e­tary out­look, as the Fed un­der­lines its in­ten­tion to move to­wards the FOMC’s in­ter­est rate fore­cast of 2% to 3% by the end of 2018. What­ever the cause, in­vestor com­pla­cency—on eco­nom­ics, on mon­e­tary pol­icy and on pol­i­tics—is about to be tested. And with the sea­son for fi­nan­cial hur­ri­canes just start­ing, in­vestors may be wise to pull down the shut­ters and stay in­doors.

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