Prepare for hurricanes
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.
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.
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.