“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” – Hyman Minsky
It’s remarkable that in an era in which a world leader tweets threats of nuclear Armageddon with the same irreverence as the latest missive out of the Kardashian family, financial markets remained pinned at historically low levels of volatility.
In fact, despite an abundance of ugly headlines and unprecedented levels of political uncertainty, the last year has marked one in which measures of volatility have only gone in one direction – down.
Trading has been absolutely placid – the S&P 500 has racked up consistent incremental gains, trading at all-time highs without so much as a 5% pullback in nearly a year.
Blue chip equities are not an outlier – across the board traders have seen a dynamic of ever lower volatility and consistently rising prices across equities, fixed income and even the most fickle of emerging markets.
It’s easy to be sanguine. For the first time in nearly a decade, we have synchronised global growth. Unemployment continues to hit multidecade lows in the United States, while much of the world follows suit, and headline corporate earnings remain solid.
What’s to worry about?
Obviously, ever-rising asset prices and lower volatility in investment markets should be a cause for celebration. But in financial markets as in life, the consequences of excess are inevitable.
Economists, central bankers and analysts alike debate the origins of the current regime of ever-rising asset prices against a backdrop of exceptionally low volatility. But at the end of the day the theorizing is largely irrelevant.
More worrying has been the concurrent increase in debt and financial leverage which has accompanied the relentless rise in valuations across the world.
Growing imbalances in this area of the financial sector can set the stage for a dramatic reversal in fortunes if levels of volatility return rapidly to their long-term averages.
In financial terms this is called a Minsky Moment, named after a well-regarded though obscure economist who achieved posthumous fame in the wake of 2008’s global financial crisis.
Hyman Minsky wanted to understand why financial crisis appeared to be an unavoidable fact for all capitalist economies. Drawing on his research, he theorized that long periods of stability inevitability sowed the seeds of the next financial crisis.
It was the collective behaviour of investors, corporates and Joe-six-pack alike that were at root. Inspired by the combination of favourable news, low volatility and looser financial conditions, excessive risk taking is incentivized along with the use of increasing levels of debt to finance those bets.
Ultimately the process feeds on itself as continued gains draw more and more participants to bid up the price of risky assets, building imbalances until the financial system resembles a house of cards ready to tumble at any widespread reassessment of risk or external shock to the economy.
The conclusion of Minsky’s work is unsettling – in essence, long periods of economic stability breed instability.
So what does that mean for financial markets in the fall of 2017?
The reality is that, despite the good news around the prospects for growth within the real economy, the financial markets are likely in a much more fragile position then they appear.
Unlike 2007, financial institutions have much higher levels of equity to buffer any shocks to their loan portfolios, so it doesn’t seem likely that there is widespread systemic risk to the financial system.
That’s a positive, but outside of that signs of excess abound in covenant light lending, capital market valuations and even the enormous popularity of completely unregulated Initial Coin Offerings.
At this stage a retrenchment in risk tolerance could quickly spell disaster for the value of most financial assets. This would imperil the current state of growth in the real economy, while also hammering investors and speculators a like.
Forex markets would not emerge unscathed; the likely consequence of a dramatic sell off in risk assets would be a rise in safe-haven currencies like the yen, US dollar and the Swiss franc. Conversely, emerging market currencies, which have seen a nice run this year, should expect some pain, and the uptick in volatility will be sure not to leave other currencies unscathed.
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