‘The Negative Tail Has Become Fatter’: Extreme Outcomes, Policy And Populism

Generally speaking, central bank largesse and forward guidance served to insulate markets from increasingly unpredictable politics in 2016 and 2017.

The effectiveness of forward guidance and asset purchases in keeping rates volatility suppressed and thereby guarding against a disorderly unwind amid rolling political shocks is probably one of the most underappreciated dynamics in markets.

One easy way to visualize this is to plot monetary policy uncertainty (as proxied by rates vol.) with political “implied vol” (as proxied by the global economic policy uncertainty index). Here’s the chart again, for those who might have missed it earlier this month:

(Bloomberg)

Given the current setup (i.e., a world awash with debt, large piles of duration and illiquidity parked on balance sheets, etc.) a spike in rates vol. is pretty much a non-starter, which is why central banks have gone out their way to ensure monetary policy remains predictable, especially as global politics becomes more unpredictable seemingly by the week.

While there’s an argument to be made that monetary policymakers will succeed in preserving this state of affairs, there are pressing questions about whether, after nearly a decade of accommodation, central banks are hamstrung in their capacity to offset political shocks and reflate the global economy. Some argue that monetary policy is simply out of ammo, as it were.

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One paradox in this equation is that while populist movements are the main source of political risk, they are also generally proponents of fiscal stimulus, which, if implemented globally, would take some of the weight off the shoulders of monetary policy when it comes to guarding against a slowdown.

There are so many layers of irony embedded in this dynamic that it’s difficult to wrap one’s head around it. Populist movements and the resurgence of nationalism threaten to undermine global trade and commerce to the detriment of growth. Fiscal stimulus can shield an economy from those ill effects, but there’s something highly absurd about deliberately deep-sixing the global economy with policies designed to undermine the multilateral institutions that define the post-War world and then citing mounting economic headwinds as “proof” that fiscal profligacy is necessary and desirable.

Meanwhile, central banks long ago gave up on fiscal stimulus – that is, they resigned themselves to the fact that they alone would be responsible for ensuring the viability of the recovery. We’ve been over this a hundred times if we’ve been over it once. Central banks would have welcomed fiscal stimulus years ago, but having generally succeeded in engineering economic stability, piling fiscal stimulus on top of things now only serves to complicate the normalization process by raising the specter of an overheating labor market. Here’s BofAML underscoring how circular all of this has become:

Part of the reason why populism is getting traction in recent years, in our view, is that populists have money to spend. Although government debt is much higher almost everywhere than before the global crisis, interest rates are at historic lows and there is strong demand for high rated government debt. The paradox is that mainstream governments did not use fiscal stimulus enough during the crisis years, central banks stepped in to save the economy, and now populists take advantage of the low interest rates to increase deficits, at a time when the economy does not need it as the recovery is mature.

Left populism wants to increase spending. Right populism wants to cut taxes. The result in both cases is higher and often unsustainable deficits and debt. Any short-term growth impact is also not sustainable, as the economy is already at full employment and at risk of overheating in most cases, the central banks will tighten policies in response, crowding out the private sector, and eventually fiscal consolidation is inevitable.

See what I mean? It’s mind-bogglingly self-referential and the circular character of it is amplified by the fact that the rise of right-wing populism is at the heart of the rampant political uncertainty that’s contributing to slowing growth.

As a reminder, there is no question that globalization is a positive development from a utilitarian perspective. But no matter how hard we try to make sure that the benefits are distributed equally, some folks will lose out, so that a larger number of folks may gain (that’s the utilitarian aspect). Here’s BofAML, from the same February 11 note cited above:

Globalization leads to winners and losers, both in theory and practice. However, at least in theory, the benefits are more than enough to compensate for the losses. In practice, there is very strong empirical evidence that openness to international trade leads to greater prosperity and faster growth. It is therefore only a matter of distributing the benefits to compensate for the losses. The strong globalization trend in recent decades and the inability/failure of mainstream politicians to adequately compensate the losers from it have increased the public’s objection against free international trade.

Right. But “the public” is generally incapable of understanding that simply blaming globalization and then electing someone who promises a quick fix by rolling it back, has the potential to be a disaster.

While some populists point to globalization as the source of the problem when it comes to explaining why the middle class in developed economies is stuck in a rut (to speak colloquially), undermining globalization risks horrendous outcomes for that same middle class as the ripple effects of protectionism start to manifest themselves in, for instance, i) downstream job losses that far outweigh (economically speaking) the “resurrection” of long-dead domestic industries that might benefit from tariffs, ii) the offshoring of production as companies facing retaliatory tariffs seek to preserve unfettered access to foreign markets, iii) subsidies made necessary by trade friction (just ask an American farmer), and on and on.

Those are but a handful of examples. The deleterious side effects for the global economy and for global markets will continue to pile up as time goes on. That isn’t an opinion – it is a statement of fact. Indeed, the very interconnectedness that some populist politicians implicitly cite as the “problem”, means that attempting to sever those connections will be accompanied by traumatic consequences. Globalization has a built-in poison pill. You can’t dismantle it without killing yourself in the process.

For BofAML, we have transitioned away from a world where advanced economies were defined by “limited downside” to a world where “extreme scenarios” are possible across developed markets.

Here is the bank explaining how things “used to be”:

Before the global crisis of 2007-09, we used to think that policies would not change much in advanced economies and that things could not go “terribly wrong.” In almost all cases, political parties with a chance to be elected were somewhat to the right, or somewhat to the left of the center, with relatively small differences from the mainstream consensus. This suggested broadly responsible fiscal policies, open international trade, and international cooperation and coordination, particularly through global organizations and institutions… This had led to a market belief that policies, almost everywhere, and as a result the global economy, would only improve in the long term; the only question was how fast and which countries would do the best.

And here is BofAML to explain how things are now:

Today we see strong evidence that populism in global politics is on the rise, risking extreme outcomes. According to the Timbro Populism Index for Europe, populism has been on an upward trend since the late 1990s and is currently at the highest level of the last four decades. Right-wing populism has been increasing since the mid1980s, but the trend accelerated in the early 2000s and even more since 2014. Left-wing populism was on a clear downward trend up to the global crisis, but has increased sharply since then. As a result, populist parties now participate in the government and are elected in parliaments more than ever before.

Obviously, not all manifestations of populism in 2019 are in favor of deglobalization, isolationism and nationalism, but so far, the most successful movements are, whether you look at Brexit, the anti-immigrant League in Italy or Trump.

The problem for traders and investors in all of this is that, as alluded to above, the interconnectedness of the global economy is mirrored in markets. And while that interconnectedness means the butterfly effect is remarkably efficient, liquidity vacuums and algos mean that price discovery is sometimes remarkably inefficient. That, guys and gals, is a bad combination.

For BofAML’s Athanasios Vamvakidis, this means that finding a safe haven in FX can be a difficult task these days. Believe it or not, the excerpts from the BofAML note cited above are from an FX strategy note. Here’s Vamvakidis summing up the implications in the FX context, but really, this could apply across assets:

The challenge that investors face in this new regime is finding a “safe haven” for the long term. 2nd and 3rd round effects and cross-border spillovers complicate the picture further. The negative tail has become fatter.

Yes, “the negative tail has become fatter.”

That goes for markets and society more generally.