Kolanovic: "This Is What The Next Crisis Will Look Like"

Tyler Durden's picture

There are two distinct parts to the latest, just released research note from JPM's quant "wizard" Marko Kolanovic.

In the first part, the infamous predictor of market swoons takes on an unexpectedly cheerful demeanor, and explains why contrary to his recent market outlooks, near-term risks for a market selloff appear to have abated. First, he looks at the tax-related rotations within the market in the past month, and notes that in September "the administration drip-fed US tax reform news, which propped up the market and spurred large sector rotations." As a result, "financials, Industrials, and Materials were up ~5%, Energy ~9% and Small Caps ~7%. On the other side of the Tax trade were bond proxies (Utilities, Staples, REITs) down ~2-3% and Technology-heavy Nasdaq that was down ~0.5%. These offsetting sector moves reduced the typically elevated September volatility to its lowest level since 1964."

He then goes on to note that in addition to the tax rotations, "volatility was reduced as market rose and got pinned at the 2,500 level for most of the month (this level was popular with option sellers,  leaving dealers locally long gamma)."

Picking up on what Deutsche Bank's Aleksandar Kocic has been writing about in recent weeks, namely the apparent failure of "exogenous shocks to shock the market", as shocks themselves become endogenous phenomena, Kolanovic also writes that in fading daily headline risk, "tax reform and infrastructure will remain a central focus for investors, and it seems that bits and pieces of information can still excite fund managers", something he previously called the ‘Trump Put’ effect.

As a result, between rotations and fundamentals, the coast - at least for the near-term - appears to be clear:

"With the upcoming positive Q3 earnings season, uptick in global growth, promise of tax reform keeping fundamental funds invested, and low volatility keeping systematic strategies invested, near-term risks of a sell-off have abated."

Putting this view into a trade recommendation, Kolanovic says that "our equity market upside trades include upside on Small Caps, Financials, Value and diversified tax-beneficiaries basket."

However, there is a "but", and taking a cue from BofA's Michael Hartnett who similarly predicted an "Icarus Rally" for the next few months before the "Humpty Dumpty" collapse of markets driven by the reflexive nature of reduced central bank intervention, "these positive developments may prompt central banks to proceed with normalization, setting the stage for the end of the cycle."

* * *

Which brings us to the second, key part of Kolanovic's note, which in turn is the JPM quant's take of what Deutsche Bank's Jim Reid wrote in his fantastic annual report published last month, namely what will cause the next crisis or as Kolanovic puts it, "What Will The Next Crisis Look Like?"

In brief, Kolanovic believes that the next crisis - which he dubs the Great Liquidity Crisis -  will be defined by severe liquidity disruptions resulting from market developments since the last crisis, including:

  • Decreased AUM of strategies that buy value assets
  • Tail risk of private assets
  • Increased AUM of strategies that sell on “autopilot”
  • Liquidity-provision trends
  • Miscalculation of portfolio risk
  • Valuation excesses

His advice: address these issues on a portfolio level to mitigate the impact of the future financial crisis, although since we doubt anyone will do that until it is too late, we fear his "macroprudential advice" will be lost on most traders and certainly regulators.

What is most interesting, however, is his vision of what happens if not enough measures are not taken in advance of what could be a cataclysmic event: his first and most controversial prediction is that central banks around the globe will have no choice but to "explicitly target" asset prices, i.e., buy stocks:

What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor (e.g., see here).

Kolanovic notes that other ‘out of the box’ solutions "could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others. To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). "

Echoing DB's Jim Reid, Kolanovic almost hints that a possible end of the current, fractional reserve system could involve a "significant change in the monetary system", i.e. a return to hard assets, perhaps in the form of a new gold standard, although with hyperinflation likely preceding such an outcome:

While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.

However, most interesting is his prediction on the social consequences from the next Great Liquidity Crisis, which would be nothing short of revolution:

The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968.... Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis.

The dour conclusion: "How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade."

And with that in mind, and to avoid losing anything in translation, here is the full excerpt of the key section from Kolanovic's just released Kolanovic report:

What Will the Next Crisis Look Like?

Next year marks the 10th anniversary of the Great Financial Crisis (GFC) of 2008 and also the 50th anniversary of the 1968 global protests against political elites. Currently, there are financial and social parallels to both of these events. Leading into the 2008 GFC, some financial institutions underwrote products with excessive leverage in real estate investments. The collapse of liquidity in these products impaired balance sheets, and governments backstopped the crisis. Soon enough governments themselves were propped by extraordinary monetary stimulus from central banks. Central banks purchased ~$15T of financial assets, mostly government obligations. This accommodation is now expected to reverse, starting meaningfully in 2018. Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis. We will call this hypothetical crisis the “Great Liquidity Crisis” (GLC). The timing will largely be determined by the pace of central bank normalization, business cycle dynamics and various idiosyncratic events, and hence cannot be known accurately. This is similar to the 2008 GFC, when those that accurately predicted the nature of the GFC started doing so around 2006.

We think the main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis:

  • Decreased AUM of strategies that buy Value Assets: The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. The ~$2T rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption.
  • Tail Risk of Private Assets: Outflows from active value investors may be related to an increase in Private Assets (Private Equity, Real Estate and Illiquid Credit holdings). Over the past two decades, pension fund allocations to public equity decreased by ~10%, and holdings of Private Assets increased by ~20%. Similar to public value assets, private assets draw performance from valuation discounts and liquidity risk premia. Private assets reduce day-to-day volatility of a portfolio, but add liquidity-driven tail risk. Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis.
  • Increased AUM of strategies that sell on ‘Autopilot’: Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~$1T over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.
  • Trends in liquidity provision: The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. In market making, this has been a shift from human market makers that are slower and often rely on valuations (reversion), to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day volatility, but increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014 and August 2015.
  • Miscalculation of portfolio risk: Over the past 2 decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. This increases tail risk for multi-asset portfolios. An analogy is with the 2008 failure of endowment models that assumed Emerging Markets, Commodities, Real Estate, and other asset classes are not highly correlated to DM Equities. In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets). Another risk miscalculation is related to the use of volatility as the only measure of portfolio risk. Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models.
  • Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology- and internet-related stocks. Sign of excesses include multi-billion dollar valuations for smartphone apps or for ‘initial cryptocoin offerings’ that in many cases have very questionable value.

We believe that the next financial crisis (GLC) will involve many of the features above, and addressing them on a portfolio level may mitigate the impact of next financial crises. What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor (e.g., see here). Other ‘out of the box’ solutions could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others. To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.

The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, Civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis. How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article ‘the death of equities’ in 1979.

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Vlad the Inhaler's picture

Out of control inflation is a good bet after this next deflation.

VD's picture

the wizard has been wrong quite a lot of late after his string of lucky guesses ran out of steam.

VD's picture

if homeboy was/is so prescient he would have opened up his own shop and traded them soothsayer "market" visions.

 

& basement dwelling crypt0-muppetz....

Stuck on Zero's picture

I vote for a Black Swan event. NK fires an H-Bomb into the Pacific near Hawaii. The Whitehouse declares war. China and Russia say they will defend the status quo. Japan and SK opt out. We take out 100 strategic targets in NK. NK, with China's help, takes out two US battle groups with 100 Sunburn Missiles. All the markets head for zero. The Fed starts to act but the the President intervenes and puts the US on a war footing. No need to go into the consequences. Dow at 2000. Treasuries worth nothing. Real estate thrashed. Gold at $10K. Millennial wallflowers are yanked out of safe spaces on campuses and shoved into Army bootcamps.  Illegal immigrants head toward the borders. ZHers say: "Yep. Bound to happen."

VD's picture

war is the release valve of all unserviceable debt ponzi schemes. gold at 10k is about right.

JRobby's picture

"new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). "

(Laugh Track Deafening !!!!)

There would have to be some revolutionary changes made to current GOVTS. Very Unlikely. "Environmental Impacts" is a dog and pony show during intermission of kabuki theater.

GOVT'S like to wait things out. They are willing to wait another 20 years for "labor" to die off vs. bulldozing it's opiate addicted corpse into an open pit right now which would be considered in bad form.

If you don't thinks so, consider that they were willing to wait 40 years for all the fight to be out of the baby boomers before fully  implementing the destruction of the Republic which accelerated from 1997 through 2008 to where we are now. FUCKED

 

 

Escrava Isaura's picture

"This Is What The Next Crisis Will Look Like"

Financials ‘you’ are gonna go the way of the dinosaurs.

 

 

 

serotonindumptruck's picture

Washington DC would never surrender to such catastrophic loss.

We would be at DEFCON 1 before the first aircraft carrier reached the bottom of the Pacific Ocean.

https://www.youtube.com/watch?v=rY7v21Zy1yE

edit: The kinetic energy delivered from a real SS-N-22 /SS-N-25 Sunburn / Onyx missile would cut that aircraft carrier in half, even with a conventional warhead.

iampreparedru's picture

All large US cities try to vacate at the same time. Mass hysteria, oil refining stops, food deliverys stop, stores empty in one day. Millions of people living out of their cars, food runs out in 2 weeks, Fights, murder, mayham.  Its the end of the USA as we know it. I will be way down south on a mountain listening on the ham radio, hopefully surronded by family. 

hongdo's picture

+100 for entertainment value. You gota do a movie deal.

Dirtnapper's picture

That's my bet as well.  Just keep an eye over the next two weeks for a blizzard hitting the mid-west farm belt.  If the crop yield takes a dump, it's game on.

Stan522's picture

How many of these type articles have I read......?

Countless....

Agent44's picture

The Horror...T h e  H O R R O R...meanwhile SPX 3200 a-comin' Kids!! Enjoy. Make $$$!

FreeShitter's picture

The next crisis will be the middle ages redux. When? Who the fuck knows.

Winston Churchill's picture

Robots cannot get the plague, so this time there will be no end to the serfdom.

CPL's picture

They now have the location of all the Kozyrev Mirror installations.  The night of smashing mirrors is coming up next.  Even the AI is getting sick of their shit.

HRH Feant2's picture

Just imagine when people get engineered smallpox. The horror! Scarred for life and unable to post pics on social media.

Thebighouse's picture

This is a bunch of crap.  

This person hasn't a clue what the future will look like.

Like the market is overbought......so what......it says nothing about when and the extent of the next correction.

You would like to think it does.........but it doesn't.

Dream on.

StocksWayUp's picture

I was discussing this very subject with some other brokers and analysts. We agree that when the top is in there will be a sudden fall and that most likely the fall will have a geo-political start.  For now we keep trading and trying to make the most money for our clients.  Zerohedge does a good job of getting investors ready for the downfall of American markets but some are pre-maturely entering trades.  The followers of Shepwave seem to be making money on a regular basis and we also use them along with other analysts of course. 

johnnyblade's picture

Here is my grand contribution to this dialogue: Shepwave fuck off

AgAuSkeptic's picture

I just don't see how this will pan out with pharma companies. Right now they are on the cusp of a breakthrough, crazy stuff like gene editing, gene specific treatment are being talked about. Even if none of this works patients and governments are ready to pay anything to get their medicines without looking at effectiveness. Case in point is Genentech with TNKASE, the thing is a flop which does not work properly, but clicnics are forced to stock up this $6K medicine as gubmint is telling them. https://www.rxrankings.com/datatable/default/chart/zzzIAR#

NoDebt's picture

Well thank God it won't be deflation.  Deflation might help too many regular people who don't have investment portfolios.

 

OverTheHedge's picture

Imagine if the price of assets fell faster than wages fell, so that stuff in general became more affordable to wage earners at the expense of, and to the detriment of, asset owners.

Just imagine that.

Now, stop imagining fairy tales and moonbeams. The reality must be the opposite, otherwise banks will fail. Need I say more?

small axe's picture

quant wizard bollocks on an epic scale

Mena Arkansas's picture

a tail risk could be a backlash against central banks

No, a backlash would be all the bankers hanging from lamposts on Wall Street until the carrion is stripped clean.

Herdee's picture

If everybody wants out at once and there's a shortage of American dollars at the same time, then watch-out for that. They may trigger a market collapse in December where they are tightening once again into weakness. It could happen during the tax-loss selling season which is also December.

aliens is here's picture

After Vegas yesterday the next crash will not be pretty. When EBT stop working you know what will hit the fan.

khakuda's picture

Nonsense.  The market is going up because real interest rates are negative and because the Fed is trapped and will not normalize.  Financial market conditions are insanely easy.

The markets are calling the Fed's bluff and accelerating upwards as the governors continue to announce that their job is not to prevent speculative bubbles.  All a bubble needs to form and grow lareger is to hear is that  that they only person with a pin has no intention of popping it.

Amun's picture

"The markets"="The Fed"="The Treasury"=...

Exactly

HuskerGirl's picture

And the government will further restrict and control economic activity. 

How do I know?  Because the government will take every opportunity to grow.  It's what they do. 

PontifexMaximus's picture

not again this bs, ask your boss about writing an article about bitcoin, much better

moorewasthebestbond's picture

NO FEAR

 

Lighten up with one of the best cover bands ever:

 

https://www.youtube.com/watch?v=sKW9kWAIdI0

Amun's picture

How the usury made the French Revolution:

 

"

 

 

budget of the Old Regime, estimated

 

expenditures at 629 million livres and receipts at 503 million,

 

but servicing  the debt alone (interest only)

 

 

required 318 million, more than half of expenditures."

 

63% of the French income went to the banksters to pay the interest

Guess the name of the usurers

 

 

 

 

 

 

 

 

Batman11's picture

Sailing on a ship of fools with the technocrat elite.

They all think the same wrong things.


The mainstream economists that should be in the best position to work things out are hamstrung by their knowledge. They try and apply their knowledge of economics to the current situation and come up with all the wrong answers.

The answer is fundamental and sits at the base of everything.

How money, debt and banks really work, which is a world shrouded in mystery that people at the highest levels don’t know.

Milton Freidman actually knew the secret of a stable, successful economy and tried to achieve the steadily rising money supply with “Monetarism”.

He didn’t know how the monetary system worked and thought Central Bank reserves controlled bank lending with the “fractional reserve” theory of money. As everyone went along with it, one can only assume that no one in the UK, at the highest levels, understood how the monetary system worked.

“…banks make their profits by taking in deposits and lending the funds out at a higher rate of interest” Paul Krugman, 2015.

Even our Nobel Prize winning economists don’t know.

This is the “financial intermediation” theory of money and is the current favourite, though it’s even worse than the “fractional reserve” theory of money. This is why no one in the mainstream can work out 2008.

They need the “credit creation” theory of money, and with this it becomes easy to work out what is going on and how to make the financial system safer. The Basel regulations are based on the “financial intermediation” theory of money and so won’t work, as Richard Werner explains in the video.

https://www.youtube.com/watch?v=EC0G7pY4wRE&t=3s

Knowledge of money, debt and banks has been regressing since 1856, when someone worked out how the system really worked.

Credit creation theory -> fractional reserve theory -> financial intermediation theory

“A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner

http://www.sciencedirect.com/science/article/pii/S1057521915001477

Reckless bankers bring knowledge of money, debt and banks to a high point as they did in the 1930s when they came up with the Chicago Plan and understood what Glass-Steagall really did. It separated the money creation side of banking from the investment side.

We have been heading backwards again, but reckless bankers have got people asking those questions again.

“How does the monetary system really work?”

Richard Werner moves in high places, has access to Central Banks and he has managed to work it out.

 

Milton Freidman actually knew the secret of a stable, successful economy and tried to achieve the steadily rising money supply with “Monetarism”.

This knowledge seems to have disappeared by 2008.

http://www.whichwayhome.com/skin/frontend/default/wwgcomcatalogarticles/images/articles/whichwayhomes/US-money-supply.jpg

M3 is going exponential before 2008, a credit bubble is underway (debt = money)

 

 

Amun's picture

Nobel Prize

reward for compliance

Don Sunset's picture

The FED will have continued hypertension trying to sustain this system that has morphed into a blatantly corrupt/manipulated operation, that is, until the Tom Petty event occurs.  At that point it will be "lights out" for the world economy with no alternative but reset.  The FED is all in and the end will be total collapse.

Enjoy the relative good times that we have right now.

gaoptimize's picture

Everyone was pretty well fed and had access to clean drinking water in 1968.  The comming crisis will be a different situation entirely.

Anteater's picture

Used to eat corn-on-the-cob non-stop, until I swallowed my tooth.

Then the Tooth Fairy gave me a dollar, and bought a lot of candy.

I put playing cards in my spokes to buzz when I rode over to my

friend's house to share the candy and show him my missing tooth.

Then his parents took us out to get ice cream, and go to the park.

 

These and other good memories will seem like the Twilight Zone,

after what the Wall Street and Pentagon Kanamits do to America:

https://www.youtube.com/watch?v=dk01eeKMD_I

Vin's picture

Blah blah blah.  Just say it.

In the end, the private central banks will own everything and our govts will finally inform us that all of our land and assets have been pledged to these bankers as collateral.  Therefore, we own nothing and are broke.

It's all bullshit, like the Matrix but without the sci-fi.

Fantasy Free Economics's picture

Marko Kolanovic, like any other economists with a job, starts by exalting the species, first and individuals next.  Honesty on the part of everyone is assumed. One number causes another and natural incentives which cause numbers are not even noticed.The result is always mush.

http://quillian.net/blog/historys-greatest-cash-cow/

Fantasy Free Economics studies humans animals surviving and looking for comfort in a hostile universe. Comfort and happiness is found through fantasy. That is why reality is so threatening. When the collapse comes look for those harmed to look for new lies to believe in while they dis-guard the old ones.  Don't expect today's set of lies to be exchanged for anything close to the truth. The strong, according to self interest, will draw the weak into groups. New mindsets built on comforting lies will replace the old order. When the existing order falls, it won't be replaced with a truth based system.

Atomizer's picture

Can I explain something. We have commercial property in Philippines. On ocean. Haven't done shit. My ideas of many business expansion. My number one is to start a bitcoin farm.

Rodrigo Duterte is cleaning up drug curruption. 

 If I went down there, would be killed. Attempting a new startup business. Mrs Atomizer mother is high in food chain (chinese). Not going to do anything until Duterte cleans house. 

Drudge link. 

https://www.nbcnews.com/storyline/las-vegas-shooting/las-vegas-shooter-w...

 

Let me show you conversation rate of USD $100,000 to PHF. The question to ask, what bank submitted the transfer and what bank received it. 

100,000 USD =5,110,477.49PHP

wisehiney's picture

Fools believe that supply chains will hold up.

Ain't nobody making no cookies in venezuela.

8th Estate's picture

If the globalists are incompetently fighting global economic collapse, the final stage will be hyperstagflation as they restart QE programs.

A decade of global suffering and impoverishment will follow - the sheeple will blame the globalists for this disaster.

If the globalists are competently engineering chaos, the final stage will be global economic collapse.

Global governance, cashless societies and state-backed cryptocurrency will follow - the sheeple will thank the globalists for this solution.

As the globalists have spent so long competently walking the tightrope of monetary loosening/tightening and managing/jawboning markets in concert, incompetence is noticeable by its absence.

Chaos pending.

Atomizer's picture

This is why you can aquire property so cheaply when her mother lives there. It just land. On Ocean. Commercial district for a hotel. Just wait.