A look back at the headlines and market movements of the last month provides some useful color for why markets are weak and why now... As Scotiabank's Guy Haselmann warned early last month, there is a threshold point during the Fed’s attempt to normalize policy where the tide reverses and investors join in a sell-off in a race to avoid being left behind. This is why it's called the greater fool theory.
March 28: Corporate DB Plans
There are several reasons to expect substantial changes in the asset allocation policies of corporate pension plans. Those changes should result in a significant volume of assets moving from equities and other return-oriented investment classes into lower-risk liability-driven (LDI) investing strategies.
March 27: P&L Management
A comment I posted on a Bloomberg Chat this morning says it all, “herd trading, policy pivots, and terrible market liquidity are a bad combination."
This week, markets have been driven by position squaring and P&L management. There have been extraordinary price movements in various commodities and currencies due to extreme weather, the decline in the Chinese Renminbi, capital flight, Fed taper, and geo-politics. Such P&L volatility is causing decisions to be made in other, seemingly uncorrelated markets, due to the need to manage P&L risk.
These movements are of elevated concern because the investment climate of recent years has created a herd mentality. Now that global stimulus is being withdrawn, those trades are under attack and a mini-contagion is unfolding
March 24: Mini-Contagion
The US economy has shown some hints of improvement, but overall it is plodding along at a pace that is neither strong nor awful. Most economists expect momentum to improve slowly to a 3% GDP growth pace in 2014, and something slightly above that in 2015. These forecasts are probably the best-case scenario. Therefore, they have asymmetrical skew to the down side. Due to crowded positions, valuations priced to perfection, and a confluence of global economic headwinds, the riskiest financial assets also have downside distribution skews of potential outcomes.
March 20: FOMC Global Challenges
A confluence of highly concerning factors are all colliding simultaneously, adding to Yellen’s challenges.
Massive fiscal and monetary stimulus in recent years have skyrocketed asset prices, but yet developed world economies have only been able to muster 2.5% growth. The rate of global stimulus in now in decline.
EM central banks (and the RBNZ) have hiked rates. The FOMC is tapering. Japan is raising its consumption tax on April 1st (the third arrow is nowhere in sight). Geo-political tit-for-tat with Russia could spiral out of control. Russia could cause trouble in the Middle East in an attempt to lift oil prices. This would hurt the west (and economic growth), but strengthen the Russia economy.
Beijing has decimated levered carry trades by unexpectedly weakening the Yuan. Beijing is also allowing defaults. The era of riskless borrowing has come to an sudden end. If Beijing is not careful, deeply interconnected cross guarantees could unleash an uncontrollable wave of bad loan defaults. After many years of moral hazard that have fueled the credit bubble, lenders will be more careful. Growth will surely slow but Beijing is trying to prevent a hard landing.
Most investors are expecting a march to higher Treasury yields in the near term, but I think they will be disappointed. For the next few weeks, I still prefer: long 30-yr Treasuries and curve flatteners.
March 17: Global Economic Headwinds
Sanctions amongst key trading partners are one of three significant factors causing problems for global growth and ‘risk-on’ trades. (It is time for return of capital strategies – emphasis added).
1) The world’s 3rd largest economy, Japan, had disappointing growth last quarter and is about to be confronted with a consumption tax hike on April 1st. Some economists predict Japan entering recession in Q3.
2) China, the world’s 2nd largest economy, weakened its currency again last night, possibly due to fears of a hard landing as Beijing attempts to reel-in its credit bubble.
3) The Fed has begun the process of ending QE which will be followed by a process to normalize rates. Risk-seeking investors who have leaned-on the ‘Fed put’ should view ‘tapering’ as a lowering of the strike of the Fed’s out-of-the-money put. In other words, ‘tapering’ opens up the downside by skewing the risk/reward distribution for risk assets unfavorably.
March 12: Great Challenges Confront the FOMC
Bernanke’s term as Chairman was characterized initially by crisis management and then subsequently by providing ever-greater creative forms and sources of monetary stimulus. Conversely, the very first day of Yellen’s term began with a new policy that decreases the rate of accommodation, and the desire to move toward policy normalization.
In addition, the FOMC under Bernanke provided such an extraordinary amount of accommodation that Fed officials (today under Yellen) have become increasingly concerned about the risks to financial stability posed by their policies. Even the doves have expressed worries about consequences of persistently low interest rates (6 years of ZIRP) and the incentives for excessive risk-taking.
Furthermore, the geo-economic and geo-political environments are vastly different today. Central banks and governments were mostly coordinated in their attempts at stimulus during the Bernanke regime. Today, there is no coordination. As a matter of fact, many central banks have recently hiked rates and are doing so at the same time that other governments are being more austere to deal with chronic deficits and growing levels of debts.
There is great risk that the Fed’s credibility is already being tested due to concerns that it has provided too much accommodation for too long. If true, risk seeking has run too far and asset bubbles will have to unwind. In order to maintain credibility under such a scenario, the Fed should attempt to normalize policy as quickly as possible. In this light, maybe the Fed should accelerate the pace of backing away from policy accommodation now that an improved economy has given them a window of opportunity. Such a move could be spun as a signal of their confidence in the recovery. Certainly, increasing the ‘taper’ is unlikely, but the current snail’s pace takes the QE program into October and risks continuing ‘the taper’ when the economic and political backdrops become less favorable.
March 5: Herd Mentality – The Left Tail Will Follow the Right Tail
These conclusions partially explain (empirically) the herd mentality and momentum in recent years behind tight credit spreads and elevated equity prices. Investors are so fearful of missing the upside and underperforming peers that they frantically scramble to remain ahead of them (i.e., seek risk). However, the conference and paper suggests that there is a threshold point during the Fed’s attempt to normalize policy where the tide reverses and investors join in a sell-off in a race to avoid being left behind. This is why I’ve been calling it the greater fool theory.