On Tuesday, CNBC published a piece called “JP Morgan’s top quant warns next crisis to have flash crashes and social unrest not seen in 50 years“.
If you go by the title, you’d think Marko Kolanovic had just signed on to write the screenplay for Hollywood’s next big-budget summer armageddon blockbuster.
Further, if you read that linked post, you’ll also come away thinking JPMorgan’s quant team put out a new note today.
Neither of those two things are true.
CNBC does note that the excerpts from Kolanovic are from a larger report, but if you actually read that report (or skim it), you’ll quickly discover that Marko’s piece encompasses just 2 out of 160 pages.
You’ll also discover that there has been no change to Kolanovic’s positive outlook for equities both in developed and emerging markets which he laid out in his most recent note, profiled here late last month.
Marko’s contribution to the longer report is really just a reiteration of some of the structural issues he’s long warned about. In other words, this isn’t some kind of bombshell prediction meant to foreshadow a coming apocalypse, financial or otherwise.
The JPMorgan report is a department-wide piece that’s basically a retrospective, a decade on from the financial crisis. That’s the lens through which Marko’s contribution to the longer piece should be viewed.
The section penned by Kolanovic is called “What will the next crisis look like” and again, the themes will be familiar to those who have followed his career.
Kolanovic dubs the next theoretical crisis the “GLC” or, the “Great Liquidity Crisis”.
The timing of that hypothetical event will depend on a number of factors, not the least of which is how “successful” central banks are at normalizing policy after a decade of accommodation without accidentally triggering liquidity disruptions. Simply put, the central bank liquidity spigot is being gradually turned off, and when that bid dissipates, someone (i.e. private investors) will need to step in to replace it.
Ok, so what will the characteristics of the “GLC” be? Well, as the name suggests, the next crisis will be marked by liquidity disruptions that stem from some, if not all, of the following post-crisis developments.
- Shift from Active to Passive Investment.
- Increased AUM of strategies that sell on “autopilot.”
- Trends in liquidity provision
- Miscalculation of portfolio risk.
- Tail risk of private assets.
- Valuation excesses.
- Rise of populism, protectionism, and trade wars
Again, Marko has broached these subjects before and while it’s always great when he elaborates on anything, it’s important to view the note in context – it’s a kind of thought experiment that aims to describe what the next crisis might look like in terms of the risk factors Marko has discussed on numerous occasions in the past.
On the epochal active-to-passive shift, Kolanovic notes that “the ~US$2 trillion 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.” Here’s the key chart which is of course a visual that has been passed around for years:
Moving on, Kolanovic talks a bit about how passive and systematic strats will almost invariably exacerbate market turmoil if conditions become acute enough. To wit, from the note:
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 ~US$1 trillion 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.
As a reminder, that isn’t speculation. In the wake of the February VIX quake, forced selling almost undoubtedly contributed to the correction in U.S. equities. On some estimates, CTAs and risk parity de-risked to the tune of some $200 billion.
On liquidity provision, Kolanovic briefly reiterates the points he’s made in the past, points which have since been parroted by analyst after analyst, blogger after blogger (including yours truly). “In market making, [there] 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)”, Marko writes, adding that while “this trend strengthens momentum and reduces day-to-day volatility, it increases the risk of disruptions.”
Here’s a visual that shows how E-mini market depth responded during volatility spikes:
When Kolanovic talks about “miscalculation of portfolio risk”, he simply means the possibility that bonds won’t be as good of a hedge for equities in the next downturn given how low rates already are and given that central banks may be hamstrung in their ability to purchases assets due to the already bloated size of their balance sheets. Diversification risk came calling in the week prior to the February selloff.
“Another risk miscalculation is related to the use of volatility as the only measure of portfolio risk”, Kolanovic goes on to say, adding that “very expensive assets often have very low volatility, and despite the downside, risks are deemed perfectly safe by these models.” That recalls worries raised by Goldman last summer, when the bank flagged the extent to which tech was becoming synonymous with multiple factors used to construct smart-beta products, including some based on low vol.
Marko goes on to say the following about private assets:
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 the downside, risks are deemed perfectly safe by these models. Private assets reduce day-to-day volatility of a portfolio but add liquidity-driven tail risk.
Again, that’s well worn territory. In the post-crisis environment, “liquidity is the new leverage”, to quote recent research from Goldman. You get paid to take liquidity risk for a reason – because it’s risky to hold illiquid assets.
Moving on, the “Valuation excesses” problem is readily apparent across assets and it’s the result of nine years of policy accommodation. Here’s Kolanovic on that:
Given the extended period of monetary accommodation, many assets are at the high end of their historical valuations. This is visible in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology and internet-related stocks have very questionable value).
Finally, and, perhaps most importantly, Marko warns on populism and how the dangers only show up with a lag.
“While populism has been on the rise for several years, this year we have started to see its significant negative effect on financial markets as trade tensions have risen between the U.S. and numerous countries”, Kolanovic writes, before warning that “the great risk of trade wars is their delayed impact.”
Over the past several months, we’ve written voluminously about the extent to which populism promises short-term gains at the expense of long-term considerations. As one analyst put it off the record last week, “populists promise short-term highs regardless of long-term costs.”
After outlining the characteristics of the “GLC”, Kolanovic closes by drawing a parallel with 1968 as follows:
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, polarized, and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from liberal to alt-right movements to conspiracy theorists and agents of adversary foreign powers. In fact, many recent developments such as the U.S. presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis.
That strikes at the heart of what many believe is the deterioration of civil discourse in America. To the extent populism anno 2018 derives some of its appeal from the disenchantment of the working class in developed markets, social media and unfettered access to information (some of which is permeated by, to quote Marko, “conspiracy theorists and agents of adversary foreign powers”), have polarized that sentiment by connecting like-minded individuals in a digital environment where face-to-face interaction and nuance has been replaced by 140- and 280-character vitriol.
So, that’s the full rundown of Marko’s contribution to JPMorgan’s tome, which, again, is a comprehensive piece with multiple authors written to commemorate the crisis and discuss the changes that have occurred in markets and society since.
To reiterate, Marko’s piece is not a new call on the market and as far as I know, Kolanovic and his team are still generally upbeat on equities and retain their year-end 3,000 PT on the S&P. Additionally, I haven’t seen anything that suggests Marko’s team has changed their positive outlook on EM equities which, as of their latest note, they think should be bought on recent weakness.
As I explained at length in “You Mortals Weren’t Ready For JPMorgan’s Marko Kolanovic – And Marko Wasn’t Ready For You Mortals“, it’s important to read Marko in context and avoid the temptation to try and pigeonhole his analysis based on mischaracterizations of his research that you might have read in the media and/or on other blogs.