Unwinding Threats

Last week’s global sell-off – the worst since January, 2014 – had all the features that make such market events both frightening and exciting for investors. It serves as a reminder to policymakers of the latent threats to financial stability and the implication this carries for growth and jobs. It also provides insights for the bumpier road that lies ahead.

The sell-off was sharp, sudden and generalised. In just a few days, the downturn erased the year-to-date gains for major equity indices, with virtually every segment – both large and small – experiencing significant losses. To add insult to injury, conventional correlations among asset classes broke down as the spillover of the equity market correction spread beyond corporate credit.

Commodities also sold off, as did the safest of all havens, German and US government bonds. As such, well diversified asset allocations did little to mitigate portfolio risks.

Rather than being driven by a single factor, last week’s correction reflected the cumulative impact of multiple causes that markets could no longer shrug off, given their high valuations and unbalanced investor positioning. They covered geopolitical, financial, economic and policy factors.

On the geopolitical front, markets could no longer ignore mounting tensions that risk disrupting global growth, trade and energy. They include the escalating violence in Ukraine, along with the widening Moscow-West divide that it fuels; civilian deaths in Gaza, and the risk of future radicalisation; the deteriorating rule of law in Iraq and Libya and the continuing fragmentation of Syria.

On the financial front, Argentina’s debt default highlighted the extent to which today’s sovereign debt regimes are sensitive to the disruptive influence of intransigent minority holdout creditors facing entrenched governments. Meanwhile, economic data out of Europe accentuated concerns about the region’s weak recovery. And, on the policy side, more hawkish statements from a growing number of US Federal Reserve officials raised some questions about the Central Bank’s resolve to continue its steadfast support for markets and the economy.

Having already rallied beyond levels easily validated by underlying fundamentals, markets were no longer able to ignore the compounding risks of such a set of factors. The result was a generalised retreat with virtually no place to shelter other than in cash and true cash equivalents; or, at least, no shelters that are readily accessible to many investors. Professional investors could protect their portfolios using both short-positioning and insurance, via credit default swaps, though many loathe the costs and risks that these entail.

The breakdown in traditional correlations among different asset classes renders such a sell-off even more unsettling, potentially triggering investor reactions that compound the initial adverse market moves. Over the years, I have found two tools particularly helpful for understanding these reactions.

Behavioural finance reminds us that certain characteristics, such as natural herding tendencies and destabilised framing mindsets, encourage subsequent market overshoots. And the “Markets for Lemon” hypothesis, formulated by George Ackelof in 1970, explains why information asymmetry and signalling problems expose both strong and weak securities to large market sell-offs notwithstanding quite large differences in their fundamentals.

These insights are likely to prove particularly relevant given the extent to which the prior period of volatility repression by central banks has induced investors to leverage positions and, in the process, compress a whole host of risk premia (including credit, default, equity liquidity and volatility). At the same time, there is little appetite among broker-dealers to warehouse risk. Indeed, rather than serving as a shock absorber, their current approach to balance sheet management initially amplifies market overshoots.

All this should also worry western policymakers. Due to political problems that preclude the use of a comprehensive policy approach, they have been forced to rely on asset markets as the conduit for attaining their growth and employment objectives. As such, the higher the probability of generalised market sell-offs, the greater the risks to financial stability and the wellbeing of Main Street.

Yet technical sell-offs also offer opportunities for those able and willing to underwrite high price volatility. Because they initially hit both strong and weak assets, investors can pick up good assets at overly depressed prices. The hope is that such investors can, and will, act in enough numbers and on a sufficiently timely basis to avert economic damage from generalised market downturns.


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