Broker Check

The Next Financial Crisis?

| August 17, 2017
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Recently, several well-known market prognosticators have called for stock market investors to start heading for the exit as we enter a seasonally weak period for the market. While it’s true that September is historically the toughest month for stock market investors this, by itself, is not a sound economic rationale for caution. In examining more bona fide reasons for concern it is useful to note that, over the past fifty years, almost all economic recessions in developed economies stem from three sources: fiscal policy contractions, monetary policy tightening, or financial crises.

Generally speaking, fiscal tax and spending policy seems broadly constructive. In the U.S., the discussion centers on the size and nature of tax reform and infrastructure spending – both of which are expansionary in nature. A more ominous concern is the economic threat posed by protectionist policies. The U.S. recently entered talks to renegotiate NAFTA and President Trump has called for a probe of Chinese intellectual property practices. The outcome of these developments could lead to policy measures that stifle international trade and lead to economic contraction.

For the past few years, monetary policy has been very lenient and supportive of asset prices. Many believe this environment may come to an end soon as the Federal Reserve Board (the Fed) may raise rates more aggressively. Based upon the Fed’s ‘dot plots’, there is a fairly wide disparity of opinion between the hawkish and dovish members of the Board. However, ignoring outliers on either side, the latest dot plot showed that 10 of the 16 members think that the fed funds rate will rise to between 2.625% and 3.125% by the end of 2019 – implying either 5, 6, or 7 quarter point raises over the next two years. These rate hikes, along with a reduction of the Fed’s bond buying (QE) program, would present a much different monetary environment. It is noteworthy that, based on the fed funds futures markets, the rest of the investing world remains skeptical as to whether the Fed can and/or will follow through with these rate hikes. If the Fed does raise rates in December, it may indicate that the Board is resolved and that further monetary tightening may be forthcoming.

Frankly, our greatest concern is for the last category of economic issues: financial crises. Fiscal and monetary policies are closely followed, and developments move at ‘human’ speeds so investors can see and react. The potential for a financial crisis, by way of contrast, does not seem to be on the radar of market watchers, policymakers, or the press. This is mainly because the issues that caused the most recent crisis (that occurred almost a decade ago) have been addressed and the system is much stronger with respect to those concerns. However, in the interim, new threats have emerged as a result of the market structure and the investing environment. Specifically, there are three issues which could, taken together, cause a financial crisis:

  • Artificially low volatility caused by the ‘short VIX’ trade: The CBOE Volatility Index (the VIX) has been very low recently. Beyond low realized market volatility (as discussed in our May blogpost), the other reason for this phenomena is that many hedge funds and professional traders have been actively shorting the VIX for many years. They do this to take advantage of the term structure of VIX pricing: The VIX is priced lower for the current month than for future months; As a result, a trader can sell a VIX contract and then, as it becomes cheaper with the passage of time, buy the contract back and sell another VIX contract with more time until expiration (and for a higher price). This is known as a ‘carry trade’ and the result is that there are many large short positions in the market. Unfortunately, a large move in the stock market could lead to problems if this trade needs to be unwound quickly. Note that on August 10th, when the S&P 500 fell by 1.5% due to tension between the U.S. and North Korea, the VIX was up 44%. In the event of a more prolonged and pronounced down move in the stock market, the VIX may increase dramatically, and the secondary effects of the liquidation of the short VIX trade could spill over to the market in general.
  • Passive ETF trading: As Exchange Traded Funds and passive index products generally take on more market share of financial assets, systemic risks rise. This is because passive investment vehicles hold little or no cash and the management of these funds are strictly rules-based. So, if investors sell these funds, then this will automatically result in selling entering the stock market because managers have no cash cushion and cannot use discretion. Some ETFs have gathered so much capital that the funds themselves are major shareholders of the corporations which they passively own. As a result, significant selling in these ETFs could have an outsized impact on the stock price of these component companies.
  • Lower volatility and lower correlations leading to higher allocations to risk assets: Many institutional investors employ asset allocation mechanisms that adjust for changes in asset volatility and correlation. As a result of the recent low volatility and low correlation between different asset groupings, these investors have taken on higher equity allocations. The rationale is a fair one: because volatility and correlations are low, better returns (through higher equity allocations) may be achieved without taking on more than targeted risk levels. Unfortunately, as volatility and correlations rise, the unwinding of this process may lead to a cascade effect as higher volatilities and correlations lead to selling, which leads to still higher volatilities and correlations, which leads to still more selling, etc.

One can imagine that these three facets of the current investing terrain could reinforce one another and lead to substantial and sustained downside momentum, the effects of which may be short-lived or longer-term. Additionally, a financial crisis brought on by these factors could develop without warning due to the automated nature of the trading programs involved. This is by no means a forecast of things to come. Our purpose in mentioning this possibility is simply to remove it as a potential ‘black swan’ event for investors, and make it a prospect that can be acknowledged and accounted for.

Regardless of the underlying cause of economic upheaval, there are many ways that investors can protect themselves including: (1) rebalancing portfolios to confirm that target allocations are being maintained, (2) taking advantage of the low correlations between asset groupings to ensure that portfolios are appropriately diversified, and (3) considering defensive factor exposures so that downside risks are mitigated. Consistent portfolio monitoring and maintenance means that investors can be prepared whenever market turbulence occurs.

Please contact me at andrew@lpastrategic.com if you have questions about the contents of this post.

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