Why fi­nan­cial mar­kets un­der­es­ti­mate risk

To­day's econ­omy is in a “risk-on” pe­riod, when in­vestors ex­change safe-haven as­sets like US Trea­sury Bills for riskier ones, from real es­tate to carry-trade cur­ren­cies. But when such be­hav­iour as­sumes that eco­nomic con­di­tions are more sta­ble than they are

Financial Nigeria Magazine - - Contents - By Jef­frey Frankel

Dur­ing most of 2017, the Chicago Board Op­tions Ex­change Volatil­ity In­dex (VIX) has been at the low­est lev­els of the last decade. Re­cently, the VIX dipped be­low nine, even lower than in March 2007, just be­fore the sub­prime mort­gage cri­sis nearly blew up the global fi­nan­cial sys­tem. In­vestors, it seems, are once again fail­ing to ap­pre­ci­ate just how risky the world is.

Known col­lo­qui­ally as the “fear in­dex,” the VIX mea­sures fi­nan­cial mar­kets’ sen­si­tiv­ity to un­cer­tainty – that is, the per­ceived prob­a­bil­ity of large fluc­tu­a­tions in the stock mar­ket’s value – as con­veyed by stock in­dex op­tion prices. A low VIX sig­nals a “risk-on” pe­riod, when in­vestors “reach for yield,” ex­chang­ing US Trea­sury bills and other safe-haven se­cu­ri­ties for riskier as­sets like stocks, cor­po­rate bonds, real es­tate, and car­ry­trade cur­ren­cies.

This is where we are to­day, de­spite the va­ri­ety of ac­tual risks fac­ing the econ­omy. While each of those risks will prob­a­bly re­main low in a given month, the un­usu­ally large num­ber of them im­plies a rea­son­ably strong chance that at least one will ma­te­ri­al­ize over the next few years.

The first ma­jor risk is the burst­ing of a stock-mar­ket bub­ble. Ma­jor stock-mar­ket in­dices hit record highs in Septem­ber, in

the United States and else­where, and eq­uity prices are high rel­a­tive to bench­marks like earn­ings and div­i­dends. Robert Shiller’s cycli­cally ad­justed priceearn­ings ra­tio is now above 30 – a level pre­vi­ously reached only twice, at the peaks of 1929 and 2000, both of which were fol­lowed by stock-mar­ket crashes.

We also face the risk of a burst­ing bond­mar­ket bub­ble. For­mer US Fed­eral Re­serve Board Chair Alan Greenspan re­cently sug­gested that the bond mar­ket is even more over­val­ued (or “ir­ra­tionally ex­u­ber­ant”) than the stock mar­ket.

The mar­ket is ac­cus­tomed to fall­ing bond yields: both cor­po­rate and govern­ment bonds were on a down­ward trend from 1981 to 2016. But in­ter­est rates can’t go much lower than they are to­day; in fact, they are ex­pected to rise, par­tic­u­larly in the US, though the Euro­pean Cen­tral Bank and other ma­jor cen­tral banks also ap­pear to be en­ter­ing a tight­en­ing cy­cle. If, say, an in­crease in in­fla­tion gen­er­ates ex­pec­ta­tions that the Fed will raise in­ter­est rates more ag­gres­sively, a stockor bond-mar­ket crash might re­sult.

Geopo­lit­i­cal risk is also high – in­deed, it has rarely been higher than it is to­day, just as faith in the sta­bi­liz­ing in­flu­ence of US global lead­er­ship has rarely been lower. The most acute risk re­lates to North Korea’s ad­vanc­ing nu­clear pro­gramme, but there are also sub­stan­tial risks in the Mid­dle East and else­where.

Th­ese risks are be­ing ex­ac­er­bated by US Pres­i­dent Don­ald Trump, who has made a num­ber of for­eign-pol­icy mis­steps, from mis­han­dling the North Korea cri­sis to threat­en­ing to ab­ro­gate the Iran nu­clear agree­ment. So far, the con­se­quences of Trump’s wild rhetoric on the do­mes­tic front have been lim­ited, be­cause most of it has not been trans­lated into leg­is­la­tion. But on the in­ter­na­tional front, it could have dis­as­trous im­pli­ca­tions.

Beyond Trump’s capri­cious­ness is a broader cri­sis in US pol­i­tics. Though show­downs in the US Con­gress over the debt ceil­ing did not re­sult in a govern­ment shut­down this month (read Septem­ber), US lead­ers have only kicked the can down the road to the end of the year, when the stakes could well be higher and the stale­mate more in­tractable. The US may even face a con­sti­tu­tional cri­sis, if Spe­cial Coun­sel Robert Mueller were to find, for ex­am­ple, ev­i­dence of il­le­gal con­tact between the Trump cam­paign and the Rus­sian govern­ment.

The last time the VIX was as low as it is to­day, in 2006 and early 2007, one could also draw up a lengthy list of po­ten­tial crises. Most ob­vi­ous, hous­ing prices in the United King­dom and the US were at record highs rel­a­tive to bench­marks like rent, rais­ing the risk of a col­lapse. Yet mar­kets acted as if risk was low, driv­ing down the VIX and US Trea­sury bill rates, and driv­ing up prices of stocks, junk bonds, and emerg­ing-mar­ket se­cu­ri­ties.

When the hous­ing mar­ket did crash, it was re­garded as a sur­prise. The crash lay out­side any stan­dard prob­a­bil­ity dis­tri­bu­tion that could have been es­ti­mated from past data, an­a­lysts de­clared, and was there­fore a black swan event, or a case of “Knigh­t­ian un­cer­tainty,” rad­i­cal un­cer­tainty, or un­known un­knowns. Af­ter all, the an­a­lysts ar­gued, hous­ing prices had never fallen in nom­i­nal terms be­fore.

But, while nom­i­nal hous­ing prices had not fallen in the US in the pre­vi­ous 70 years, they had fallen in Ja­pan in the 1990s and in the US in the 1930s. This was, there­fore, not a case of Knigh­t­ian un­cer­tainty, but of clas­si­cal un­cer­tainty, in which the data set gen­er­at­ing the prob­a­bil­ity dis­tri­bu­tion was un­nec­es­sar­ily lim­ited to a few decades of do­mes­tic ob­ser­va­tions.

In this sense, it is the “black swan” term that fits best – in­deed, bet­ter than those who use it re­al­ize. Nine­teenth-cen­tury Bri­tish philoso­phers cited black swans as the quin­tes­sen­tial ex­am­ple of a phe­nom­e­non whose oc­cur­rence could not be in­ferred from ob­served data. But that, too, re­flected a fail­ure to con­sider data from enough coun­tries or cen­turies. (The black swan is an Aus­tralian species that had been iden­ti­fied by or­nithol­o­gists in the eigh­teenth cen­tury.)

This type of fail­ure to take a suf­fi­ciently broad view turns out to be a key rea­son why in­vestors pe­ri­od­i­cally un­der­es­ti­mate risk. The for­mu­las for pric­ing op­tions, for ex­am­ple, re­quire a sta­tis­ti­cal es­ti­mate of the vari­ance. Like­wise, the for­mula for pric­ing mort­gage-backed se­cu­ri­ties re­quires a sta­tis­ti­cal es­ti­mate of the fre­quency dis­tri­bu­tion of de­faults. An­a­lysts es­ti­mate th­ese pa­ram­e­ters by plug­ging in just the last few years of data for the given coun­try. More­over, in the boom-bust cy­cle de­scribed by Hy­man Min­sky, a pe­riod of low volatil­ity lulls in­vestors into a false sense of se­cu­rity, lead­ing them to be­come over-lever­aged and ul­ti­mately pro­duc­ing a crash.

Per­haps in­vestors will re-eval­u­ate the risks af­fect­ing the econ­omy to­day, and the VIX will ad­just. But, if his­tory is any guide, this will not hap­pen un­til the neg­a­tive shock, what­ever it is, ac­tu­ally hits.

Wall Street Bull, New York City

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