The US 10-year Treasury bond is the benchmark for global interest rates and stock markets. And for the past 30 years it has been heading steadily downwards as the chart shows:
- US inflation rates finally peaked at 13.6% in 1980 (having been just 1.3% in 1960) as the BabyBoomers began to move en masse into the Wealth Creator 25 – 54 age group
- Instead of simply boosting demand, as during the 1960s-1970s, they began to work and create new supply
- This meant supply/demand began to rebalance and interest rates then peaked at 16% in 1981
By 1983, the average Western Boomer (born between 1946-1970) had arrived in the Wealth Creator cohort, which dominates consumer spending, and the economy really began to hum. There was a final inflation scare in 1984, when US inflation suddenly jumped from 3% to 5%, but after that the trend was downwards all the way.
The Boomers were the largest and wealthiest generation that the world had ever seen. Their move to become Wealth Creators completely transformed the inflation outlook, as more and more Boomers joined the workforce. And they transformed the economy by moving it into the NICE era of Non-Inflationary Constant Expansion.
Central bankers took credit for this move, claiming it was due to monetary policy. But in reality, people are the key element in an economy, not monetary policy. You can’t have an economy without people. And sadly, the idea that the US Fed Chairman Alan Greenspan had somehow become a Maestro, blinded everyone to 2 key issues for the future:
- Life expectancy was rising rapidly, meaning that the Boomers would not normally die just after retirement. Instead, they would likely live for another 15 – 20 years after reaching age 65
- From 1970, fertility rates had fallen below replacement level (2.1 babies/woman) across the Western world
This combination of a rise in life expectancy and a collapse in fertility rates was creating a timebomb for the economy.
THE RISE IN LIFE EXPECTANCY AND COLLAPSE OF FERTILITY RATES CREATED AN ECONOMIC TIMEBOMB
Western economies are based on consumer spending. And spending declines once people reach the age of 55 – they already own most of what they need, and their incomes decline as they approach retirement, as the second chart shows:
- There were 65m US Wealth Creator households in 2000, who spent an average of $62k ($2017)
- There were only 36m in the 55+ cohort, who spent just $45k each
- In 2017, there were 66m Wealth Creators (almost the same as in 2000) who spent $64k each
- But there were now 56m in the 55+ cohort, who spent just $51k each
The rise in 55+ spending was also only temporary, as large numbers of Boomers have just reached 55+ and have not yet retired. Spending by those aged 74+ was down by nearly 50% versus the peak spending 45-54 age group.
BELIEF IN MONETARISM LED TO THE DOTCOM AND SUBPRIME DISASTERS
The dot-com crash in 2000 should have been a wake-up call for the failure of monetarism. It also, after all, marked the moment when the oldest Boomers began to join the 55+ cohort. But instead, policymakers thought monetarism could solve “the problem” and cut interest rates to boost the housing market – causing the subprime crash in 2008.
One might have thought – as we wrote in Boom, Gloom and the New Normal in 2011 – that this disaster would have destroyed the monetarism myth. But no. Abandoning monetarism would have led to a difficult conversation with voters about the need for everyone to retrain in their 50s, and prepare to take on new, and less physically demanding, roles.
Instead, policymakers tried to replace lost BabyBoomer demand by printing vast amounts of free money via the Quantitative Easing and Zero Interest Rate Policies. Their aim was to avoid deflation, as inflation had fallen to just 0.6% in 2010 – although why this was a “bad thing” was never explained. But in reality, they were running uphill, and the pace of the climb was becoming more vertical, as the average Western Boomer joined the 55+ cohort in 2013.
Of course, flooding the market with cheap money boosted asset prices, as they intended. Stock markets and house prices soared for a second time. But it also created a major new risk. More and more investors began to panic as they hunted through the markets, trying to obtain a decent “return on capital”. They assumed central banks would never let markets fall, and so gave up worrying about the risk of making a dud investment.
INTEREST RATES ARE NOW HEADED HIGHER AS PEOPLE WORRY ABOUT RETURN OF CAPITAL
The end of the Bitcoin bubble has highlighted the fact that that risk and reward are normally related. Most investments that offer potentially high rewards are also high risk – a lot has to go right, for them to make the possible return. This process of price discovery – the balance of risk and reward – is the key role of markets.
Left to themselves, markets will price risk properly. But they have been swamped for the past decade by central bank liquidity and their crucial role has been temporarily destroyed. Now, the fact that the US 10-year bond has broken out of its 30-year downtrend tells us that markets they are finally starting to regain their role.
How high will interest rates now go? We cannot yet know, and we can also be sure they will not move in a straight line as central banks will continue to intervene. But as more and more investments, like Bitcoin, prove to be duds, so more and more investors will start to worry about return of capital when they invest.
4% therefore looks like the next level for rates, as we are now trading within the blue bars on the chart. It may not take very long for this level to be reached, given the fact that the world now has a record $233tn of debt – 3x the size of the global economy. After that, we shall have to wait and see.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
I now plan to begin monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. The first forecasts relate to last week’s post on US polyethylene exports and today’s forecast for the US 10-year Treasury bond. I will change confidence levels as and when circumstances change.
The post US Treasury benchmark yield heads to 4% as 30-year downtrend ends appeared first on Chemicals & The Economy.
Last year it was the near-doubling in US 10-year interest rates. In 2015, it was the oil price fall. This year, there is really only one candidate for ‘Chart of the Year’ – it has to be Bitcoin:
- It was trading at around $1000 at the start of 2017 and had reached $5000 by August
- Then, after a brief correction, it stormed ever-higher, reaching $7000 last month
- On Friday it was trading around $19000 – fortunes are being made and lost all the time
The beauty of the concept is that nobody really has a clue about what it is all about. You can read the Wikipedia entry as many times as you like, and still not gain a clear picture of what Bitcoin is, and what it does. But why would you want to know such boring details?
All anyone has to know is that its price is going higher and higher. Plus, of course, there is the opportunity to laugh at stories of people who bought Bitcoins, but then lost the code – for an excellent example by a former editor of WIRED (with a happy ending), click here.
But there is another side to the story, as the second chart suggests. “Mining” Bitcoins now uses more electricity than a number of real countries, like Ireland, for example:
- On Friday, Bitcoin’s current annual consumption reached 33.73TWh – equivalent to Belarus’ 9 million people
- Each transaction produces 117.5kg of CO2, as the network is powered by cheap coal-fired power plants in China
- It also uses thousands of times more energy than a credit card swipe
And, of course, interest is growing all the time as people rush to get rich. Today sees the start of Bitcoin futures trading on the CME, a week after they began on the CBOE and CME. Bloomberg suggests Exchange Traded Funds based on Bitcoin will be next. In turn, these developments create more and more demand, and push prices ever-higher.
Comparisons have been made with the Dutch tulip mania in 1836-7, when prices peaked at 5200 guilders. At that time, Rembrandt’s famous Night Watch painting was being sold for 1600 guilders, and at its peak a tulip bulb would have bought 156000lbs of bread. Bitcoin probably won’t equal this ratio until next year, if its current price climb continues.
Of course, one key difference between tulips and Bitcoin is supposedly that there were always more tulips to buy – whilst there are just 21 million Bitcoins available to be mined. And apparently, around 80% of these have been mined. Bitcoin enthusiasts therefore suggest Bitcoins will have increasing scarcity value. But, of course, anyone can create a crypto-currency and many people have – such as Bitcoin Cash and Bitcoin Gold, and the Ethereum family.
Yet already, Bitcoin’s market capitalisation* is getting close to that of the “tech stocks” such as Apple, Alphabet (formerly Google), Microsoft, Amazon and Facebook as the chart from Pension Partners shows:
- On 7 December, less than 2 weeks ago, its market cap was already higher than major US stocks such as Home Depot and Pfizer
- On Friday, it hit $323bn, above Wal-Mart and P&G and close to ExxonMobil
- This also made it worth more than the IMF’s Special Drawing Rights
- And the total market cap of the 10 largest crypto-currencies has now reached $500bn, equal to Facebook
This is an amazing amount of money to be tied up in an asset which has no intrinsic value. After all, what is Bitcoin? It certainly isn’t real, although the media like to picture it as a gold coin:
- Although it is called a crypto-currency, its volatility makes it unattractive as a currency – major changes in a currency’s value can easily cause businesses (and countries) to go bust, and Bitcoin’s value has moved by 1900% just this year
- Nor is it a method of settling transactions, as its value is increasing all the time – obviously a good deal for the person who receives the Bitcoin when its price is rising, but why would any sensible person pay with a Bitcoin?
- So essentially, therefore, Bitcoin is simply a speculative asset, where its value is based on the “greater fool theory”, which says “I know its not really worth anything, but I am clever enough to sell out before it hits the top”
The “story” behind its boom is also powerful because it is linked to the great investment theme of our time, the internet. We have all seen the fortunes that can be made by investing in companies such as Apple. Now, Bitcoin supposedly offers us the chance to invest in the Next Big Thing – a new currency, entirely based on the internet.
BITCOIN HAS MANY PARALLELS WITH OTHER MANIAS IN HISTORY, SUCH AS THE SOUTH SEA BUBBLE
The Bitcoin mania has many parallels, such as with the South Sea Bubble from 1719 – 1720. Its power was also based on “the greater fool theory”, and its linkage to the great investment theme of its time – the opening up of foreign trade. As the chart from Marc Faber shows, one of its early investors was Sir Isaac Newton – one of the most intelligent people ever to live on the planet, who discovered Newton’s laws of motion and invented calculus. Newton doubled his money very quickly when he first invested, but then re-invested at a higher price – and lost the lot.
Of course, all the dreams associated with Bitcoin and the other crypto-currencies may come true. That is part of their attraction. Another part of their attraction is for criminals, who can launder money without being traced. So most likely, prices will continue rising for some time as more and more people around the world see a chance of getting rich very quickly. We have never seen a global mania before, so nobody can tell how long it will last.
The question for governments, however, is what would happen to the economy if the mania collapsed? Only China has so far banned Bitcoin trading, as Pan Gongsheng, a deputy governor of the People’s Bank of China, explained:
“If we had not shut down bitcoin exchanges and cracked down on ICOs several months ago, if China still accounted for more than 80% of the world’s bitcoin trading and ICO fundraising, everyone, what would happen today? Thinking of this question makes me scared.”
Having let the mania develop this far, other governments are in a difficult position – millions of people would complain if they closed down these currencies today. And most governments are reluctant to intervene as, in reality, crypto-currencies are essentially the creation of central bank stimulus policies, as explained by US Federal Reserve chairman, Ben Bernanke, in November 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
But by letting the mania continue, the potential impact from its collapse will increase. Added together, crypto-currencies already have the same market cap as Facebook – and could soon overtake Apple to become the most valuable “stock” in the world. Yet unlike Apple, they have no sales, no income and no assets.
Bernanke and the major central banks wanted to stimulate investors’ “animal spirits”, so that they would take on more and more risk. Crypto-currencies are therefore the logical end result of their post-crisis strategy. The end of the Bitcoin mania, whenever it occurs, will therefore also mark the end of stimulus policies.
*Bitcoin’s market capitalisation is its equity valuation – the current dollar price multiplied by the number of Bitcoins in existence
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The world is coming to the end of probably the greatest financial bubble ever seen. Since the financial crisis began in 2008, central banks in China, the USA, Europe, the UK and Japan have created over $30tn of debt.
China has created more than half of this debt as the chart shows, and its total debt is now around 260% of GDP. Its actions are therefore far more important for global financial markets than anything done by the Western central banks – just as China’s initial stimulus was the original motor for the post-2008 “recovery”.
Historians are therefore likely to look back at last month’s National People’s Congress as a key turning point.
It is clear that although Premier Li retained his post, he has effectively been sidelined in terms of economic policy. This is important as he was the architect of the stimulus policy. Now, President Xi Jinping appears to have taken full charge of the economy, and it seems that a crackdown may be underway, as its central bank chief governor Zhou Xiaochuan has been explaining:
- Zhou first raised the issue at the National Congress last month, warning of the risk of a “Minsky Moment” in the economy, where debt or currency pressures could park a sudden collapse in asset prices – as occurred in the US subprime crisis. “If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. We should focus on preventing a dramatic adjustment.”
- Then last week, he published a warning that “China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing. [China] should prevent both the “black swan” events and the “gray rhino” risks.”
We can be sure that Zhou was not speaking “off the cuff” or just in a personal capacity when he made these statements, as his comments have been carried on both the official Xinhua news agency and on the People’s Bank of China website. As Bloomberg report, he went on to set out 10 key areas for action:
- “China’s financial system faces domestic and overseas pressures; structural imbalance is a serious problem and regulations are frequently violated
- Some state-owned enterprises face severe debt risks, the problem of “zombie companies” is being solved slowly, and some local governments are adding leverage
- Financial institutions are not competitive and pricing of risk is weak; the financial system cannot soothe herd behaviors, asset bubbles and risks by itself
- Some high-risk activities are creating market bubbles under the cover of “financial innovation”
- More companies have been defaulting on bonds, and issuance has been slowing; credit risks are impacting the public’s and even foreigners’ confidence in China’s financial health
- Some Internet companies that claim to help people access finance are actually Ponzi schemes; and some regulators are too close to the firms and people they are supposed to oversee
- China’s financial regulation lags behind international standards and focuses too much on fostering certain industries; there’s a lack of clarity in what central and regional government should be responsible for, so some activities are not well regulated
- China should increase direct financing as well as expand the bond market; reduce intervention in the equity market and reform the initial public offering system; pursue yuan internationalization and capital account convertibility
- China should let the market play a decisive role in the allocation of financial resources, and reduce the distortion effect of any intervention
- China should improve coordination among financial regulators”
Clearly, Xi’s reappointment as President means the end of “business as usual” for China, and for the support provided to the global economy by Li’s stimulus policies. Xi’s own comments at the Congress confirm the change of direction, particularly his decision to abandon the idea of setting targets for GDP growth. As the press conference following the Congress confirmed, the focus is now on the quality of growth:
“China’s main social contradiction has changed and its economic development is moving to a stage of high-quality growth from a high-rate of expansion of the GDP,” said Yang Weimin, deputy head of the Office of the Central Leading Group on Financial and Economic Affairs. “The biggest problem facing us now … is the inadequate quality of development.”
Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property, is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.
No country in the world now has a top quality pension system. That’s the conclusion from the latest Report by pensions consultants Melbourne Mercer. As the chart above shows:
- Denmark and The Netherlands have fallen out of the top category
- In the G7 wealthy nations: Canada is in category B; Germany and UK in C+; France, US and Italy in C; Japan in D
- In the BRICS emerging economies: Brazil is in category C; India, China and S Africa are D; and Russia’s system is so poor it is unclassified
Unsurprisingly, the cause of the problems is today’s ‘demographic deficit’, as the authors highlight:
“The provision of financial security in retirement is critical for both individuals and societies as most countries are now grappling with the social, economic and financial effects of ageing populations. The major causes of this demographic shift are declining birth rates and increasing longevity. Inevitably these developments are placing financial pressure on current retirement income systems. Indeed, the sustainability of some current systems is under threat.”
These problems have been building for years, as politicians have not wanted to have difficult conversations with voters over raising the retirement age. Instead, they have preferred to ignore the issue, hoping that it will go away.
But, of course, problems that are ignored tend to get worse over time, rather than go away. In the US, public pension funds saw their deficits jump $343bn last year to $3.85tn – making it almost certain that, eventually, pension benefits will have to be cut and taxes raised.
The issue has been that politicians preferred to believe central bank stimulus programmes could solve the deficit by cutting interest rates and printing large amounts of virtually free cash. And unfortunately, when it became clear this policy was failing to work, the banks “doubled down” and pursued negative interest rates rather than admitting defeat:
- Currently, 17% of all bonds (worth $8tn), trade at negative rates
- Swiss bond yields are negative out to 2027, as the Pensions Partners chart shows
- Most major European countries, and Japan, suffer from negative rates
2 years ago, Swiss pension experts suggested that its pension system would be bankrupt within 10 years, due to the requirement to pay retirees an annuity of 6.8% of their total savings each year. This rate is clearly unaffordable with negative interest rates, unless the funds take massive risks with their capital.
The US faces similar problems with Social Security, which is the major source of income for most retirees. The Trustees forecast its reserves will be depleted by 2034, when benefits will need to be cut by around a quarter. Medicare funds for hospital and nursing will be depleted by 2029. And as the Social Security Administration reports:
“173 million workers are covered under Social Security. 46% of the workforce in private industry has no private pension coverage. 39% of workers report that they and/or their spouse have not personally saved any money for retirement.”
Rising life expectancy is a key part of the problem, as the World Economic Forum (WEF) reported in May. Back in 1889, life expectancy was under 50 when Bismarck introduced the world’s first state pension in Germany. Today, the average baby born in the G7 countries can expect to live to be 100. As WEF conclude:
“One obvious implication of living longer is that we are going to have to spend longer working. The expectation that retirement will start early- to mid-60s is likely to be a thing of the past, or a privilege of the very wealthy.”
Sadly, politicians are still in denial, as President Trump’s proposed tax cuts confirm.
Today is not 1986, when President Reagan cut taxes in his October 1986 Tax Reform Act and was rewarded with higher tax revenues. 30 years ago, more and more BabyBoomers were entering the wealth creating 25 – 54 age group, as the chart from the Atlanta Fed confirms:
The issue is the ageing of the Boomers combined with the collapse of fertility rates:
- The oldest Boomers left the Wealth Creator cohort in 2001, and the average Boomer (born in 1955) left in 2010
- The relative number of Wealth Creators is also in decline, as US fertility rates have been below replacement level (2.1 babies/woman) for 45 years since 1970
Inevitably, therefore, Reagan’s demographic dividend has become Trump’s demographic deficit.
As I warned back in May, debt and demographics are set to destroy Trump’s growth dream. And without immigration, the US working age population will fall by 18m by 2035, making a bad situation even worse. Instead of tax cuts, Trump should instead be focused on 3 key priorities to:
- “Design measures to support older Boomers to stay in the workforce
- Reverse the decline that has taken place in corporate funding for pensions
- Tackle looming deficits in Social Security and Medicare”
Future retirees will not thank him for creating yet further debt headwinds by proposing unfunded tax cuts. These might boost GDP in the short-term. But they will certainly make it even more difficult to solve tomorrow’s pension deficits.
Global interest rates have fallen dramatically over the past 25 years, as the chart shows for government 10-year bonds:
UK rates peaked at 9% in 1995 and are now down at 1%: US rates peaked at 8% and are now at 2%
German rates peaked at 8% and are now down to 0%: Japanese rates peaked at 4% and are now also at 0%
But what goes down can also rise again. And one of the most reliable ways of investing is to assume that prices will normally revert to their mean, or average.
If this happens, rates have a long way to rise. Long-term UK interest rates since 1703 have averaged 4.5% through wars, booms and depressions. If we just look more recently, average UK 10-year rates over the past 25 years were 4.6%. We are clearly a very long way away from these levels today.
This doesn’t of course mean that rates will suddenly return to these levels overnight. But there are now clear warning signs that rates are likely to rise as central banks wind down their Quantitative Easing (QE) and Zero Interest Rate stimulus policies. The problem is the legacy these policies leave behind, as the Financial Times noted recently:
“In total, the six central banks that have embarked on quantitative easing over the past decade — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, along with the Swiss and Swedish central banks — now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.
“Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments. The ECB’s total balance sheet recently topped that of the Fed in dollar terms. It now holds $4.9tn of assets, including nearly $2tn in eurozone government bonds.”
The key question is therefore ‘what happens next’? Will pension funds and other buyers step in to buy the same amount of bonds at the same price each month?
The answer is almost certainly no. Pension funds are focused on paying pensions, not on supporting the national economy. And higher rates would really help them to reduce their current deficits. The current funding level for the top US S&P 1500 companies is just 82%, versus 97% in 2011. They really need bond prices to fall (bond prices move inversely to yields), and rates to rise back towards their average, in order to reduce their liabilities.
The problem is that rising yields would also pressure share prices both directly and indirectly:
Some central banks have been major buyers of shares via Exchange Traded Funds (ETFs) – the Bank of Japan now owns 71% of all shares in Japan-listed ETFs
Lower interest rates also helped to support share prices indirectly, as investors were able to borrow more cheaply
Margin debt on the New York Stock Exchange (money borrowed to invest in shares) is now at an all time high in $2017. Ominously, company buy-backs of their shares have already begun to slow and are down $100bn in the past year.
House prices are also in the line of fire, as the second chart shows for London. They have typically traded on the basis of their ratio to earnings
The average ratio was 4.8x between 1971 – 1999
But this ratio has more than doubled to 12x since 2000 as prices rose exponentially during subprime and then QE
The reason was that after the dotcom crash in 2000, the Bank of England deliberately allowed prices to move out of line with earnings. As its Governor, Eddie George, later told the UK Parliament in March 2007:
“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.
Today, however, the Bank is finally recognising – too late – that it has created a bubble of historical proportions, and is desperately trying to shift the blame to someone else. Thus Governor Mark Carney warned last week:
“What we’re worried about is a pocket of risk – a risk in consumer debt, credit card debt, debt for cars, personal loans.”
Of course, the biggest “pocket of risk” is in the housing market:
Lower interest rates meant lower monthly mortgage payments, creating the illusion that high prices were affordable
But higher prices still have to be paid back at the end of the mortgage – very difficult, when wages aren’t also rising
The Bank has therefore now imposed major new restrictions on lenders. They have ordered them to keep new loans at no more than 4.5x incomes for the vast majority of their borrowers. And lenders themselves are also starting to get worried as the average deposit is now close to £100k ($135k).
Of course, London prices might stay high despite these new restrictions. Anything is possible.
But fears over a hard Brexit have already led many banks, insurance companies and lawyers to start moving highly-paid people out of London, as the City risks losing its “passport” to service EU27 clients. Over 50% of surveyors report that London house prices are now falling, just as a glut of new homes comes to market. In the past month, asking prices have fallen by £300k in Kensington/Chelsea, and by £75k in Camden, as buyers disappear.
The next question is how low could prices go if they return to the mean? If London price/earning ratios fell back from today’s 12x ratio to the post-2000 average of 8.2x level, average prices would fall by nearly a third to £332k. If ratios returned to the pre-2000 level of 4.8x earnings, then prices would fall by 60% to £195k.
Most Britons now expect a price crash within 5 years, and a quarter expect it by 2019. Brexit uncertainty, record high prices and vast overs-supply of new properties could be a toxic combination, perhaps even taking ratios below their average for a while – as happened in the early 1990s slump. As then, a crash might also take years to unwind, making life very difficult even for those who did not purchase when prices were at their peak.
Interviewed for this Reuters article, I suggest today’s low levels of market volatility could be “the calm before the storm”
Saikat Chatterjee and Vikram Subhedar, AUGUST 11, 2017 / 5:06 PM
LONDON (Reuters) – After this week’s war of words between the United States and North Korea triggered the biggest fall in global stocks since the U.S. presidential election, investors are wondering what other off-radar shocks may be waiting to rock world markets.
Although there is little sign so far that investors are protecting themselves against a major sell-off, some say the current environment masks latent risks.
“Every day, our risk models tell us to take more risk because of falling volatility but with markets being where they are, we have to be very careful in not following them blindly,” said James Kwok, head of currency management at Amundi in London. ”So we try to project scenarios on what can go wrong and where are markets not looking.”
Such has been the extraordinary period of stability in financial markets in recent years that world stocks have hit a series of record highs while gauges of broad market volatility have plunged to record lows. That benign investment environment has been fostered by central banks which have pumped vast sums of cash into economies since the global financial crisis that began a decade ago, lifting asset prices globally.
Flows into most asset classes have already overtaken peaks reached before the financial crisis. For example, inflows into active and passive equity funds have nearly doubled to $10.9 trillion at the end of June 2017 from a September 2007 peak, according to Thomson Reuters Lipper data. Inflows into bonds have meanwhile increased nearly three-fold to $4.1 trillion in that period.
Broad market gauges of risk, such as the CBOE Volatility Index .VIX, better known as the VIX, and its bond market counterpart, the Merrill Lynch Option volatility index .VOL remain pinned near record lows despite a spike this week. But analysts say low market volatility masks the heavy weight of options written on these gauges by investment banks betting that the calm conditions will persist for a long time.
That has been accompanied by the growing popularity of inverse-volatility ETF products, which have doubled in value this year as market volatility has cratered. Morgan Stanley strategists say the volume of bets on volatility remaining low means even a small increase in price swings could force some of these leveraged bets to unwind, triggering shock waves in the financial system and sending stock markets tumbling.
Daily percentage changes are important in the volatility world because a lot of these exchange-listed products and notes are rebalanced daily based on these changes, so that any large change would automatically trigger selling pressure elsewhere.
“This is why lower volatility creates higher risk,” said Christopher Metli, a Morgan Stanley quantitative derivatives strategist in a recent note. He estimates that a 12 point rise in the VIX could send the S&P 500 index down by 3.5 percent. A move of that magnitude was last seen after Britain’s shock Brexit vote in June 2016.
But a spike in volatility is not the only scenario worrying investors.
Other risks markets may be ignoring include the implications of a messy British exit from the European Union and the risks that the Qatar crisis could spiral out of control in the Middle East and hit oil prices. Even the prospect of a newcomer at top of the U.S. Federal Reserve when Janet Yellen steps down in 2018 could prove unnerving.
“Today’s low volatility is the calm before the storm and doesn’t reflect the real world in which companies are operating, or the major uncertainties that are developing,” said Paul Hodges, chairman at International eChem, a consultancy.
Another variable is the expectation that central banks will soon start unwinding their massive post-crisis stimulus measures, with unpredictable results. One of the biggest risks seen lurking is the rise and growing influence on the world’s stock markets of passive funds, which aim to track rather than beat benchmarks and charge lower fees than their more actively-managed peers.
The proportion of stocks on the main U.S. benchmark equity index that are now owned by such passive investors has nearly doubled since the 2008 crisis to 37 percent. But redemption pressures on large passive investors could exacerbate any market selloff.
Apple Inc (AAPL.O), a stock market darling, has a fifth of its outstanding stock held by index funds with Vanguard, BlackRock and State Street making up the top three holders, according to latest Thomson Reuters data. The head of sales of a large British-based bond fund said some of its clients are trying to put together pools of money with which to snap up beaten-down stocks if a large emerging market-focused ETF is faced with sudden redemption pressures.
“We get a lot of queries on what are some of the risks that markets may be overlooking, and that is what keeps us up at night,” he said.
Reporting by Saikat Chatterjee and Vikram Subhedar, Graphic by Saikat Chatterjee and Ritvik Carvalho; Editing by Catherine Evans