Markets remain calm despite political uncertainty.
How many times have you heard that statement or some derivation of that statement over the past four years?
The ostensible paradox of suppressed cross-asset vol. in the face of rampant and proliferating political uncertainly became a fixture of markets post-2015.
Generally speaking, the disconnect between political uncertainty (or, “politicians’ implied vol.“, if you will) and various measures of market volatility has been explained by reference to monetary policy. Central bank forward guidance and accommodation encouraged and facilitated a relentless, global hunt for yield, compressing risk premia, underwriting the viability of various carry trades and leading to a scenario where “trades and strategies which explicitly or implicitly rely on the low-vol. environment continuing [became] more and more ubiquitous” (to quote a November 2017 Citi note).
“When spreads are low, volatility is low and dispersion is low, a few basis points of carry can matter a lot to a fund’s percentile performance against peers and against the short-term metrics by which performance tends to be measured many will struggle to forego the incremental carry – until a negative trigger becomes immediately obvious”, Citi wrote, in a separate note dated early 2017. “And so the game of musical chairs continues, even as the stakes seem to be getting higher and higher.”
That became self-fulfilling as the “swarm” effect took hold. Resistance was not only futile, but also a sure path to underperformance. Here’s how Deutsche Bank’s Aleksandar Kocic put it back in July of 2017:
It is all about the decision whether to align your prospects with or against everyone else’s. At the moment, investors face a difficult choice. On one side, you are tempted to join the crowd. After all, the Fed is the “guarantor” so, despite the downsides, embracing the carry trade might not be a totally unsafe option (and you get rewarded for that). For most people who operate over a short time horizon, this is the only option.
Again, that dynamic largely explained the market mode and, in turn, the disconnect between the heightened political uncertainty which began to manifest itself in increasingly contentious politics in and around Europe’s migrant crisis in 2015. Those contentious politics fed populist sentiment which ultimately led to Brexit, France’s brush with “President Marine Le Pen” (gasp) and, of course, Donald Trump.
Fast forward to 2019 and, after a turbulent year during which the Fed’s efforts to normalize policy and re-emancipate markets contributed to multiple unwinds and episodic bouts of market turmoil, cross-asset vol. has collapsed anew amid what has been variously described as a central bank “blink for the ages.”
As we’ve been over on dozens of occasions, it’s no surprise that rates vol. has been the “anchor” (so to speak).
“Other measures of risk premia, like credit spreads and cross-market volatilities, seem to be gradually relaxing, but are settling wider relative to rates [and] in our view, this is a consequence of the distribution of risks and the path of stimulus unwind”, the above-mentioned Aleksandar Kocic writes, in his latest note, dated Friday.
Said differently, vol. ratios (expressed as VIX, CVIX and credit vol divided by 3M10Y) have come off local highs, but are still elevated versus their pre-October levels.
After dispensing with the necessary discussion of record-low rates vol., Kocic delivers a characteristically brilliant critique/hypothesis regarding the juxtaposition between collapsing cross-asset volatility and political entropy.
He starts by rehashing the points detailed above about what generally happens when volatility collapses and investors chase out the risk curve in search of returns. To wit, from the note:
Investors face fixed long-term liabilities and, in order to meet those demands, they look for return by taking risk. As volatility declines, investors take higher risks which further compresses risk premia and engenders “unwelcome behavior”. This mechanism is self-reinforcing and in the end leads to forced deleveraging and recession.
Obviously, not much is different in the post-crisis world with regard to the first part of that equation – that is, investors still face fixed long-term liabilities. What has changed, though, is the extent to which leverage can be deployed in order to bridge the gap.
“Tighter regulations and balance sheet restrictions, while instrumental for stability, are now limiting leverage and forcing the persistent gap between profits and liabilities, which now has to be tolerated by investors”, Kocic writes.
What does that mean from a big-picture perspective?
Well, as Kocic goes on to say, it entails “more aggressive saving and less consumption which impairs growth.” That, in turn, means “the proverbial ‘pie’ doesn’t get bigger and the economy converges to the zero-sum game.”
Of course if the pie isn’t getting bigger, then the only question is one of redistribution. Kocic underscores this and, in course of doing so, flips the oft-repeated “markets remain calm despite political uncertainty” line (where we began this post) on its head. Here’s Aleks:
The stability extends as long as the eye can see, but it is an intoxicating stability marked by stagnation. In the zero-sum markets, the only game is redistribution, and politics is a consequence of this mode of economic and market functioning. Thus, political entropy and turbulence is a consequence of calm markets. This is the direction of causality. (The inverse causality encapsulated in the statement that ‘markets remain calm despite political uncertainty’ is misleading.) And, the calmer markets get, the more volatile the politics can become in the process of swinging between different modes of redistribution, which can feed back into even calmer markets.
In the current paradigm – the only one we know — calm markets cause volatile politics and volatile markets appear as prerequisite for peaceful political life.
Clearly, that has all manner of societal ramifications and serves as a remarkably poignant critique of the prevailing political landscape.
Indeed, the veracity of Kocic’s assessment is readily apparent in the current state of American political discourse which is increasingly couched in terms of wealth redistribution in an environment where engineering growth is becoming more and more difficult as everyone appears to be pushing on a string in one way or another.