A Drier Forest

It seems like every time the market tries to rally on the back of great fundamentals, some exogenous shock pulls it right back down.  First it was VIX and vol-selling, then LIBOR-OIS, then Argentina and Turkey, and now Italy and trade wars.  Are these events just “noise” or is there a pattern here?

These patterns of weakness are most likely a direct consequence of reduced central bank buying. The artificial, large, and sustained buying presence of Quantitative Easing flooded financial markets with liquidity and dramatically suppressed volatility.   As QE evaporates, markets have to adjust and rediscover how to price risk.  And while they’re adjusting to these new realities, there will be volatility.

While the individual shocks may be unpredictable, I think investors have to take into account the vulnerabilities of any complex system.  Global markets are incredibly complex systems, and it’s impossible to calculate all of the ways shocks can reverberate across them.  Rather than trying to anticipate a spark, I think investors should be paying attention to the dryness of the forest more broadly.  I don’t think the economic recovery is over by any means, but the “forest” (global markets) is vastly “drier” (riskier) without the support of QE than it was with it.   While growth and corporate fundamentals are strong, volatility spikes with these events for a reason, and this noise should not be looked through.

We should be hedging our bets when insurance is cheap rather than trying to predict the next shock.  If you have a some sort of predictive framework that allowed you to predict the demise of XIV and Argentina/Turkey/Italy turmoil, you probably should be raising billions of dollars and starting your own hedge fund ASAP.

The main threats to risk assets are systemic in nature, and chances of an exogenous shock sparking a global recession are higher than they were a year ago.  The most commonly accepted risk is that the fed hikes too quickly (most likely stemming from an inflation overshoot).  It doesn’t end there, though.  Anti-establishment 5SM and League parties reached an 11th-hour government deal, but the end of the Italian political crisis doesn’t mean the end of uncertainties (the focus will now be on fiscal policy and the size of the likely increase in public debt).  Further, trade war escalation could lead to higher inflation and lower growth.

In summary, there’s no shortage of risks for today’s investors.  Additionally, these risks are often unpredictable given how complex and interconnected global financial markets are.  The “forest” is a lot drier than it was when central banks were flooding financial markets with liquidity. Growth and fundamentals remain strong, so it’s ok to be in equities, but if you are, consider buying protection when it’s cheap and markets are optimistic (i.e. buying S&P puts when stocks are up and the VIX is down).

Top 10 Reads of the Week

  1. Naval: How to Get Rich (without getting lucky)
  2. 13D Research: Liquidity is the New Leverage
  3. WSJ: Why Italy is Flirting with Euro Exit and Spain Isn’t
  4. Wired: As Rental Cars Fade Away, Avis Will Try Anything to Survive
  5. MIT Technology Review: It’s Fiction, but America Just Got Wiped Out by a Man-Made Terror Germ
  6. The Economist: Does China’s Digital Police State Have Echoes in the West?
  7. The Economist: Italy Needs to Be Handled with Care
  8. Wired: How One Apple Programmer Got Apps Talking to Each Other
  9. A16Z: Decrypticng Crypto, From Bitcoing and Blockchain to ICOs
  10. CryptoEconomics: The Blockchain Economy: A Beginner’s Guide to Institutional Cryptoeconomics