Volatility in the Age of Quantitative Tightening

But what is going to change this mentality?

QE technically started in the middle of 2008 and equities reached their lows in March 2009. QE did not support equity valuations outside of the stabilization of interbank lending and the effect it had on pushing institutions into riskier assets (also known as the portfolio transmission mechanism). The stock market recovery was driven by a recovery in corporate profits. And that recovery in earnings was in turn driven by the largest global fiscal stimulus in history and a doubling of the credit base in emerging markets over the recovery period.

Now this is beginning to reverse as credit growth in emerging markets has been decelerating and the deflationary effects of austerity programs in the developed world are starting to have their impact.

At the end of the day, credit growth must translate into sustained rising incomes and velocity to create long term growth. Right now we have neither.

In past cycles we could lean on credit growth to make up for the loss in purchasing power of the middle class. But looking at private debt, we are at the highest levels in recorded history. Until this debt is written down, inequality will continue to rise against muted growth, no matter how many one-time monetary or fiscal injections policymakers try to jumpstart the global economy.

So what is the risk that pension funds should be preparing for?

Japanification, which is to say continued rise in public deficit spending to offset long-term muted growth because of too much private debt. To see why this is most likely, you have to understand both demographics and the dynamics of private credit. But investors have a hard time accepting this because the asset management business is conditioned to assume central bankers and politicians will always bailout asset prices. But looking at the Japanese experience, decades of QE can’t change the underlying demographics. If anything, QE and taxpayer-funded bailouts of systemically important financial institutions (SIFIs) halt the free market cycle of creative destruction. If the old doesn’t make way for the new, then the new technologies can emerge that reemploy the middle class.

But what about timing?

Right now is a perfect time to think about options for de-risking due to a near across the board compression in risk premia since 2009. Again this relates to faith in the Fed to backstop both equity and credit risk. Once this unwinds it will of course already be too late. The problem is that for institutions that don’t already have a dedicated derivatives team in-house, the choices are really limited. The listed VIX ETF products have a high burn rate and the data is mixed on the level of protection they would actually deliver in bear market scenarios that don’t involve an extreme event like October 2008.

What are institutions doing to diversify?

Since 2008 we have seen institutional investors increase their allocation to alternative investments like hedge funds and private equity because of the general perception of higher returns and lower correlation with stocks and bonds. The problem is that data over the last 10 years shows that alternatives have had an ever-increasing level of correlation to the broader market. The scariest part is that during the recent periods of high volatility, the correlation increases dramatically, which is exactly when you need the diversification benefit to kick in.

What has caused the higher correlation of alts with traditional investments?

There isn’t one clear explanation for this phenomenon but just taking a look at hedge funds, in the late 90s when most of the studies began the industry was still less than $200 Billion in AUM total. Now it has grown to over $3 Trillion with the top 100 managers commanding over two-thirds of those assets. Given that size and level of concentration, hedge funds will naturally become a higher beta product. So ironically, in an effort by investors to reduce risk by sticking to brand names in the space, there has been an indirect increase in risk and a corresponding decrease in the revenue potential of the industry as a whole.

What could change this trend?

If alternative investments do not deliver significant protection to the downside during the next prolonged period of high volatility, institutions will begin to abandon the asset class due to high fees.

Institutions like pension funds are already putting pressure on fees due to the impairment of public balance sheets globally, putting extra pressure on active managers to outperform.

You see this showing up in both concentration and net exposures which are at all-time highs. A lot to do with having to play catch up with the S&P 500 every year since 2009. This is a feedback loop that gets worse with every move up as managers replace shorts with index and ETFs, and add to high momentum longs in an effort to catch up. This creates a risk that if the next crisis is not a systemic one, the assets that alternative asset managers are long could actually go down more than the broader market, because of their illiquidity and concentrated ownership.

Why aren’t hedge funds a hedge?

Hedge funds have underperformed in recent years because this cycle has not rewarded deep fundamental analysis in the same way that it did prior to 2008. Since then, the market has been driven largely by the emergency measures that were taken at that time which for most of this cycle drove correlations to historical highs. Again, the price of artificial stimulus is investors want to own all assets alike. Betting on the relative value of different assets matters less and less in an environment where all assets go up indiscriminately. And again, this is because we are trying to cure a bad debt problem by adding more debt. Inevitably, with a perceived central bank backstop in place, this added liquidity finds its way back into financial assets in a perpetual growth loop.

Politicians like to talk about deleveraging, but at over $100 Trillion globally, bank debt is actually 40% higher than it was in 2007.

This goes back to the fact that the US housing market was largely backstopped by the taxpayer. Since then, low-to-middle income borrowing has been driven by 100% LTV loans from the FHA, subprime auto loans and loans to students for higher education. These are now becoming delinquent at an alarming rate.

This is the problem with the bailouts of the post-Crisis period, we were told that we needed a short-term fix to restart animal spirits and that once that happened we would be able to address the real issues. Well, we got the animal spirits part right but did not address the real issues that remain. Looking at monthly return data there is little granularity as to how those returns were made, but you can compare relative performance across strategy buckets.

As a result, hedge funds, like everyone else, have been forced to chase yields or go out of business.

Aren’t pension and sovereign wealth funds incentivized to hedge?

Yes. Large institutions are depending on alternative investments to help them mitigate volatility in their portfolio when the trend reverses. But that trend has forced the very positioning that is more concentrated on the sectors that are working. This is especially the case on the long side of the book where it could really hurt in a down market when one type of asset sells off more than the broader index, actually producing negative alpha over some periods.

Given net positing at a fraction of a long-only portfolio, this would correct with a deep market sell-off. But what about the many other markets where we don’t have a catastrophic Lehman type event? One positive thing that can be said about the bailouts is that there is a $20 Trillion global QE backstop that wasn’t there in 2007–2008, so the likelihood of a 2008 event is much lower than it was then.

The truth is that the bailouts and fiscal stimulus of the 08–09 period were fantastic for financial asset prices, but those are just marks. When house prices, or stocks or corporate bonds are trading on light volume, it can have little or no bearing on actual fundamental value. Market manipulators from the beginning of time have understood the ease of moving prices on light volume, why do we treat it any differently when the Fed does it?

This is why the ideological bedrocks of modern finance are such dangerous ideas. Policymakers can hide behind concepts like equilibrium growth, market efficiency and a random walk model of asset prices. But over and over again these theories have been disproven by empirical fact. Like people, economies and financial markets do not evolve as a series of independent coin flips. Both are the result of collective human behaviour and opinion.

Why is moral hazard bad?

The definition of moral hazard is a lack of incentive to guard against risk where one is protected from its consequences. When central banks and governments decided to bailout the bad business practices along with the good, they created a precedent for financial risk management ultimately falling on the taxpayer. Since then, risk premiums have compressed as if this will always be the case and for every tradable asset.

As dangerous as this belief is, in 2008 a system-wide collapse of the global financial and economic system was possible, and at that limit, the taxpayer stepped in to stabilize it. This is why a central banking model was created. Having dodged that bullet, it should’ve been understood that letting bad debts get to the point of catastrophic failure before we act is a bad idea.

Our theories on how the economy and markets functions should have been revised. Instead, we doubled down on the failure and just labelled it a really “great recession”, as if it were a Black Swan that no one could be expected to see coming.

But people did see it coming, and they did say something and most importantly, they tried to do something about it. Unfortunately, those voices were drowned out by the high incentives to create more debt.

Worse yet, certain market participants used that knowledge to create products they knew would blow up when the crisis happened, sold them to institutions who needed the yield and then bet against them. This behaviour was only ceremoniously punished, and as a result, the net effect is encouraging that behaviour to continue in the future. Bailouts or not, general faith in those institutions has been lost. Furthermore, this loss of trust has led to rising populism based on a general distrust of the democratic institutions that have held since the end of WW2. Ironically, it will be that loss of trust that prevents policymakers from stepping in this time around.

Where does this leave investors today?

Investors should come to the realization that a share of stock or a corporate bond is not cash, it is a risk-bearing asset. With QT, the idea of risk premium will return the conversation around valuation.

Risk now means underperforming benchmarks by missing free ‘central bank sponsored’ capital appreciation, not capital preservation.

And why shouldn’t it? If you believe that central bankers will always be there to make sure that you don’t take a real capital loss, then all financial assets become putable into a US Treasury bond struck at par. This, of course, is ultimately ridiculous because if it were to persist indefinitely, no business manager would re-invest in growing their business. Instead, they’d be incentivized to lever up and sweep all profits back into capital markets as stock buybacks or dividend them out. This is not far off from the real choice corporate managers have today where their compensation is tied to the stock price. This is why we are seeing buybacks at peak levels historically irrespective of fundamental valuation.

How will this end now that the Fed is tightening?

As nice as this free ride has been for certain well-positioned players in global markets, it is a delusion and delusions end the same way: quickly and brutally. After 1999 and 2007 it would be hard to argue that this is new knowledge, yet behaviour doesn’t change. Why? Because like Pavlov’s dog, asset managers think that the food will still be there every time the bell rings.

The conditioning of the last 10 years in the asset management business has rewarded more and more passive strategies, with fewer and fewer people tasked with understanding the big picture.

The bailouts put the food there one last time. Good fundamental securities analysis and high specialization matters less and less against a backdrop of ever rising correlations. Instead of trying to understand why this is, the incentive is to bury one’s head even further in the sand with respect to the big picture and try not to get caught off mandate making market calls.

As long as the short term trends are detectable and persistent, this works fine. But when large systems shifts occur to the whole environment, it fails miserably. This is what happened in 2008, but instead of rewarding the few who were able to shift gears and see a very obvious bubble, the bailouts further entrenched the herd chasing behaviour with the idea that if you get burned missing the forest: don’t worry, everyone else will too.

It’s hard to argue that this was a minor side effect when compared to preventing systemic collapse. What we should take issue with is revisionist history; bailed out institutions pretending they would have still been even if the government had not stepped in. Now everyone wants to rewrite history and say, “hey that was just a great recession and yes, we sustained losses but in the end, we were able to stay in business.”

No. You weren’t. Everyone had to chip in to keep you around. Most of the industry was DOA. Those that were able to stick around and meet redemptions without putting their gates up were punished. How can we begin to learn what it was that allowed those players to stay in the game when everyone gets a pass? The very foundation of free market theory is that it’s evolutionary; over time, long-term productive ideas survive and bad ideas die. Instead, it is like we are all playing a game of monopoly where those who are sitting closest to the banker get to keep playing no matter what, just because the banker used to be on their team, or will be when they retire.

All of these flaws will come back to bite us when we begin to realize that the last ten years has not been a real recovery, and that we forgot to start fixing the real problems. The recovery story is a myth.

The demographics in the West are deflationary. That is not a debate, it’s a fact. As the Baby Boomers cash out in order to live, what they sell will go down relative to what they receive. But the problem is there isn’t enough cash to pay them out, at least not at where those liabilities are marked. This is debt deflation.

What most fail to understand is not that this gap exists, it is that, no matter what, the gap will be subtracted from future generations’ ability to consume. The same Baby Boomers whose spending drove the back half of the 20th century will turn into Baby Busters as their dependency requires an ever-expanding share of everyone else’s income. Furthermore, funding this gap means selling out of financial assets to meet short-term cash obligations at a time when those who would typically buy those assets are forced to divert a larger share to taking care of the sellers.

The funding gap at pension funds is not about mismanagement or union politics. These may be issues at the margin, but the real story is the collective gap between what Baby Boomers earned as workers and what they will receive as dependents. This comes down to simple numbers and by 2030 the economic dependency ratio in the US and EU will have reached 150%. This means there will be 3 dependents for every 2 active workers. So even if it were possible to privatize social security and liquidate pension funds at current market values right now, so what? We haven’t fixed the gap, we’ve just shifted it from a pooled responsibility to an individual one. Either way, the gap still exists and still comes out of future consumption; it is just a matter of how this loss is distributed. This is why social safety nets like pension funds were created in the first place. Just because we decide not to share the burden doesn’t mean there is no burden.

What will trigger the next market crisis?

At some point soon we will enter a new phase of deleveraging where bad debts will be separated from those that can be paid off.

No one can predict exactly when this will be, but you can look at the drivers of growth over the last 10 years, look at when those are decelerating, and make appropriate preparations for accelerating risk. Right now this is exactly what is happening. Looking backwards, there were two primary drivers of this cycle: emerging market credit growth on steroids and an unprecedented global fiscal stimulus. But these factors are now slowing with Emerging Markets in the final Ponzi phase of the Minsky cycle and Developed Markets replacing fiscal stimulus (ex-US tax cuts) with austerity measures in order to deal with entitlement problem.

What isn’t obvious is just how big the impact of a tripling in Emerging Market credit base has been on the valuation of financial assets, and how big the blowback will be to Developed Markets when this finally reverses as it is beginning to now. Add to this the outright deflation in Europe, and investors are looking ever more desperately at central banks for the QE bell to ring. It’s not hard to see why prudent managers are already coming out publicly about the rising levels of global risk.

How can institutions detect this rising risk?

Most investors measure risk by looking at some fixed window over the last several years of data, and bucket their portfolio based on a mean and a standard deviation that they extract from that window. This is then projected forward and is accepted as an accurate picture of future risk. Of course there have been many advances in this method but even sophisticated statistical tools use similar assumptions to extract information about risk from historical regressions.

Unfortunately, this type of analysis suffers as a primary risk management tool at turning points like the one we are approaching. Long-term investing is a very difficult endeavour because the economy is a complex and highly non-linear system. It is not always best described by fitting data to a bell curve. Again, this idea should have been finally tossed out in 2008. Instead, we just added the financial crisis as an extreme “Black Swan” event to the distribution and slapped a few people on the wrist for making liar’s loans. This is totally facetious and intellectually dishonest. Imagine physics progressing by just relaxing assumptions to make the data fit.

The good news is that reality eventually overcomes bad scientific theories with empirical facts. The bad news is that there is nothing that stops us from choosing to ignore those facts. We see it today with climate change and if we can do it with something as fundamental as the weather, how does something as abstract as the science of the economy and financial markets even stand a chance?

The problem is that the more we ignore reality, the greater the eventual cost when we decide to finally address it.

It is this human cost, not the monetary one, that is the fundamental flaw with the whole 10-year experiment of ‘extend and pretend’. Social instability is spreading at a rapid pace and it’s plain to see that keeping the status quo afloat at the expense of the up-and-coming generation has never ever ended well throughout human history. Even in the US, we’re levering up the next generation into a labour market with falling wages and student loan debt they can’t walk away from. Worse, they’re competing with two generations ahead of them who are forced to stay in the workplace much longer than they anticipated working low-skill jobs. Today, 1 in 3 college grads are making less than 25k first year out of college, lower than it’s ever been.

In Europe, the youth unemployment rate is close to 20%. Anyone who expects some easy rebound in the middle class in US and EU is kidding themselves. We will have to address these issues as a society one way or another, and unfortunately, the only solution policymakers and economists put forth is more government spending or more quantitative easing. Both are fantastic for the status quo and financial assets in the short run, but neither does anything to fix the structural problems. In fact it makes them worse by delaying the day of reckoning.

Is there still time to act?

Yes. Now is the time for investors to take a serious look at how their portfolio will perform in a world where financial assets trade independently of government support. We must not bury our heads in the sand, managing monthly returns against a benchmark of other people doing exactly the same thing, and hope that there will be time to reverse course. In an era of QT, if policymakers lose the political will for bailouts where will investors get their liquidity when forced to sell? Unless you believe investors will work together not to sell all at once, the only way to solve this prisoner’s dilemma is by being first to the exit.