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Calm Markets Raise Big Risks for Complacent Investors

September 26, 2016

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While global economic and political developments point to the possibility of “jump conditions” once deemed improbable, financial markets have treated their influence as temporary and reversible. This divergence is understandable in the short run. Longer-term, however, it sets up complex dynamics that call for investor adaptations.

In the last few weeks, the UK voting to leave the EU and the setting of record high prices by the US equity and bond markets simultaneously added to what already has been an unusual period for a global system with more than 30 per cent of its global government debt trading at negative nominal yields. The sense of fluidity intensifies when you add to the mix fragile Italian banks, an attempted coup in Turkey, and tragic illustrations of vulnerability to lone wolf attacks.

These issues share a potential for fuelling so-called jump conditions in which there is a leap to a different set of circumstances, rather than a smooth and incremental evolution. In turn, they could change longstanding economic and financial relationships, impact the way economic agents interact with each other, fuel political anomalies and, in the case of unusual asset class correlations and valuations, undermine some of the institutions and basic tenets of the capitalist system. 

This phenomenon is not limited to the past and present. Also, there are potential jump conditions on the horizon.

The October referendum in Italy could complicate European politics already challenged by the legacy of the financial crisis, migration challenges and Brexit.

The US faces its own unusual election in November, with both presidential candidates navigating the pull of anti-establishment movements that oppose globalisation, trade agreements and elements of free markets. China’s ongoing political changes coincide with its leaders having to manage a tricky middle income development transition rendered more difficult by international economic headwinds and domestic financial bubbles.

Meanwhile, unease about policy effectiveness grows in a world that has been over-reliant on central banks and that will likely see three of these systemically important institutions (the Bank of Japan, the European Central Bank and the People’s Bank of China) pulled even-deeper into the uncharted waters of monetary policy experimentation.

Despite all this, measures of market sentiment have been remarkably calm. Just look at the VIX, the so-called “fear index” that captures the extent to which investors are unsettled by internal and external uncertainties. Spikes have been infrequent and quickly reversed. Indeed, rather than move up in a sustained manner to reflect the multi-faceted “unusual uncertainties”, its most distinguishing feature is that of overall stability at subdued levels.

There are good reasons for this. Liquidity injections — both actual and expected — remain ample on account of central bank stimulus and corporate cash being recycled back into markets via share buybacks, mergers and acquisitions. Investors have been conditioned by years in which “buy on dips” approaches have repeatedly proven profitable, especially in markets recently achieving new highs.

Few investors have rushed to reflect the reality of elevated prices and unstable asset class correlations back into their strategic asset allocation, particularly given unchanged investment objectives.

Lacking attractive alternatives, and with limits on how much cash traditional investment managers can hold, equities continue to attract a disproportionately large allocation.

It is understandable for markets to trade on the current reality of cash flow and put aside, at least for now, the possible consequences of the ever growing gap between investor behaviour and a growing list of unusual economic and political uncertainties. In the process, however, a cocktail is brewing that risks future financial volatility and jump conditions in various market segments.

Faced with this, investors would be well advised to reflect on the longer-term consequences of the significant divergence between liquidity-induced stability in markets and longer-term fundamentals in disequilibrium.

In addition to lowering the expected return from their strategic asset allocation and increasing the expected volatility of the return profile, investors should look at more of a bar-belled approach that combines higher cash allocations with greater exposure to alternatives; become more tactical; and, using scenario analyses, prepare stakeholders for unsettling volatility down the road.

The biggest mistake for investors — and it is an easy one to make — is to believe that this period of artificial market calm is destined, in itself, to lift the fundamentals that ultimately determine asset value. The opposite is, unfortunately, more likely.

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