“While the waters seem calm, vulnerabilities are building under the surface [and] if left unattended, these could derail the global recovery.” - Tobias Adrian
The International Monetary Fund (IMF) released their Global Financial Stability Report this month which highlighted some of the vulnerabilities the IMF sees in the current global economic landscape. The high level summary is that super accommodative monetary policy has been necessary to spur economic recovery and ensure markets don’t fall into a deflationary spiral. But these same policies which have kept interest rates at record lows for so long are creating vulnerabilities in the economy as debt levels continue to rise. One factor that is contributing to the continual rise in debt/leverage is the persistent low levels of volatility in the stock market, a dynamic we will unpack in more detail in this week’s post.
As everyone is keenly aware of at this point, interest rates have been at historically low levels ever since the Global Financial Crisis (GFC) hit back in 2008-09. Central banks around the developed world have intentionally kept interest rates low in order to spur economic growth by making it extremely cheap to borrow money (e.g. take on debt). In theory, if a company can borrow money at say 4% and invest that capital into their business which is growing at say 15%, then low interest rates create a “virtuous cycle” of economic growth. And that is exactly what has happened over the past 8 years to the point where the IMF believes it should be scaled back.
The problem with cheap debt is that it isn’t all used for economically beneficial purposes. I would argue that most consumer debt would fall into this category as it tends to provide a short-term boost to the economy (more consumption) at the cost of long-term sustainability of economic growth. From the aforementioned IMF report:
In advanced economies, with notable exceptions, household debt to GDP increased gradually, from 35 percent in 1980 to about 65 percent in 2016, and has kept growing since the global financial crisis, albeit more slowly. In emerging market economies, the same ratio is still much lower, but increased relatively faster over a shorter period, from 5 percent in 1995 to about 20 percent in 2016. Moreover, the rise has been largely unabated in recent years.
The other side of the same coin is that low interest rates make it difficult for investors to earn adequate returns on their capital. The low interest rate environment has forced many investors to go further out on the risk spectrum. Portfolios that used to be anchored with investment grade bonds now look much different with a mix of dividend paying stocks and high yield bonds in an attempt to generate the same level of return as pre-crisis time period.
There is too much money chasing too few yielding assets: less than 5 percent ($1.8 trillion) of the current stock of global investment-grade fixed-income assets yields over 4 percent, compared with 80 percent ($15.8 trillion) before the crisis.
Asset valuations are becoming stretched in some markets as investors are pushed out of their natural risk habitats, and accept higher credit and liquidity risk to boost returns.
The Financial Times did a follow up article where they interviewed Tobias Adrian, Director of the Monetary and Capital Markets Department at the IMF, about his biggest concerns with the current global economic environment. In the article, Tobias indicates that cheap debt and low volatility has led to investors taking on more and more risk. Many risk models used by professional investors such as pension and endowment funds use volatility as a measure of risk. With record low volatility levels, those investors are pressing the bet on their equity investments. In other words, investors have become complacent with a stock market that persistently marches upward with very little volatility.
The article goes on to provide several examples of multi-billion dollar pension funds who are now employing an investment strategy called “naked put writing” which in essence is like writing insurance on the stock market. As long as the market goes up, this strategy produces a steady stream of income from the put options which are being sold, but if/when the market turns, those same put options can become a huge liability for whoever sold them, not unlike a natural disaster for an actual insurance company.
So what happens when the music stops and the investor sentiment pendulum swings to the other side as investors clamor for the exit? It is hard to say, but one thing is for certain, strategies which target volatility with automatic sell triggers along with insurance-esk strategies like the one described above, make the financial system and global economy as a whole less stable. The reason being is that it compounds the problem of everyone running for the exit at the same time. The advent of computers and lightning fast trading algorithms have further compounded this problem as we’ve already seen in the past (e.g. Flash Crash).
This dynamic is something we worry about all the time. What potential systemic risks are lurking below the surface of the current low volatility investment environment and what can we do to protect our clients’ portfolios from such risks? The question is a fantastic one but unfortunately one that is impossible to fully answer. There are too many “unknown unknowns” out there, and anyone who tries to tell you differently is being foolish. But that doesn’t mean that steps can’t be taken to protect a portfolio against these unknown risks.
As any client or long-time reader of this blog should know, one thing we strive to do is to identify investments which are driven by different risks than those that drive the performance of the stock or bond market. If we can properly identify enough of these types of investments and spread our “risk budget” across a wide variety on uncorrelated investments, we can hopefully build a portfolio that is insulated from any singular risk factor. We call this approach to investing Diversification 2.0 since it goes beyond the traditional two-asset (stocks and bonds) portfolio. It is part of our two-pronged approach to risk management and downside protection.
It is human nature to chase performance or be lulled into thinking that current trends will persist indefinitely. This has been the case for the past 8 years as the global stock market as steadily risen in the wake of a historic sell-off during the GFC. Every day you turn on the financial news to hear about a new record high for some stock index. On top of that, volatility is at all-time lows with the S&P 500 recently breaking its previous record of 241 days without a 3% intraday drawdown. The peril of low volatility is that it lulls many investors into a state of complacency. But as the recent IMF report would suggest, just because things appear calm, doesn’t mean there isn’t risk brewing below the surface. We wholeheartedly agree with this sentiment and believe it is extremely prudent to take a more diversified approach to investing, even at the expense of additional upside in the current stock market run.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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