In recent months, something new and structurally revolutionary has been brewing in the global financial markets. This new trend, traceable in its beginnings to 2015-2016, is now highly pronounced. The same trend is also linked to the global social, economic and even political fundamentals. In simple terms, most recent signals from the financial markets indicate a structural decline in the prominence of traditional risks and the elevation of a so-called VUCA (volatile, uncertain, complex and ambiguous) environment in driving assets valuations. This structural switch – from a familiar, hedging-friendly world of risk, to an ambiguity-rich, higher uncertainty world holding promise of systemic shocks – is a hard reality to handle for investors, regulators, and the markets in general. With time, the problems of navigating through the VUCA world will also start feeding through to mainstream politics, setting the stage for the next global crisis.
While there are multiple various metrics for measuring risks in the financial markets, one of the most comprehensive and common gauges of risk perceptions among the investors is the VIX index or, using its full definition, the CBOE Volatility Index. Per CBOE, VIX “is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.” In general, both in academic and practitioner finance, VIX Index is broadly considered to be a relatively accurate barometer of investor sentiment and a decent predictor of the direction of market volatility.
Taking S&P500 and NASDAQ Composite returns, inclusive of dividends payouts, since 1997, and comparing their volatilities to VIX indicates that starting from 2Q 2016, shows that both future expected and recent historical risk measures have declined. In terms of intra-day volatility, by the end of February, the S&P500 has managed to run 50 days of uninterrupted sub-1 percent intraday volatility – the longest stretch for more than 34 years. In other words, investors and traders are no longer operating in the environment where ordinary risks materially influence markets behavior. Complacency and over-confidence are now medium-term behavioral drivers of markets prices, implying that the world of investment finance is in a rapidly developing bubble.
At the same time, also starting with early 2016, indices that measure economic and markets uncertainty have been hitting historical highs. One such measure of uncertainty is the Global Economic Policy Uncertainty Index which can be measured using the extent of media focus on policy uncertainty across the globe. The EPU Index is a de facto proxy for broader VUCA-type environment, where risks cannot be fully priced or insured against, and where markets participants are forced to rely on more intuitive understanding of the complex, ambiguous and volatility-inducing trends.
As chart 1 clearly illustrates, both VIX and the EPUI have been trending in the opposite direction since the end of 2015. More crucially, short-term and medium-term correlations between the two indices, having generally been positive on average over the last 20 years, have now turned negative. This is only the second time in history of both indices that such a reversal took place, and the current period is the longest for which all types of correlations are negative. See figure 1
In line with the EPUI, CBOE Skew Index – an index capturing the price of buying insurance contracts against larger shifts in S&P500, or an indicator of demand for extreme (tail) risk hedging – has been on an upward trend, with historically high degree of volatility. Funds inflows into gold are also accelerating: Xetra Gold Shares rose from around 60 in 2015 to around 120 by the end of 2016. The price currently stands at over 138. Finally, the Insiders Transactions Ratio (a ratio of insider sales to insider buys) – a good indicator of insiders’ pessimism about the future markets direction – is currently running around its all-time highs.
As investment markets set aside concerns about traditional short-term risks and focus on a more complex and highly ambiguous systemic uncertainty, the “smart money” investors reposition their portfolios toward short-term speculative strategies, away from long-term hold acquisitions. Which sets the stage for potential systemic crises should macroeconomic environment turn sour.
Welcome to the VUCA world
Rising likelihood and severity of the uncertainty-driven markets crises is a core feature of the VUCA environments. And the tail signs of the events ahead may already be visible on the horizon.
At the end of February, the European Financial Stability Fund, Europe’s collective undertaking backed by its sovereigns, ran into what Bloomberg called “a stunning lack of investor appetite for its long-end debt.” EFSF’s debt spreads on German Bunds rose from 21 basis points at the end of October 2016 to 69.2 basis points at the end of February.
In equity markets, complacency is the name of the game. For the S&P 500, the current forward 12-month Price-to-Earnings (P/E) ratio is 17.6. Which beats all recent historical averages: the five-year average (15.2), the 10-year average (14.4), and even the 20-year average (17.2). The latter includes the period of dot.com boom. The end of February 2017 marked the highest forward 12-month P/E since June 23, 2004. Notably, current forward 12-month P/E ratio is estimated using highly optimistic earnings per share forecasts for 2Q-4Q 2017. Should earnings fail to deliver in these expectations, the forward P/E ratio will rise even higher. In other words, markets pricing currently implies a truly excessive degree of investors’ optimism.
While much has been written about the political cycle drivers for increasing markets pressures, little is generally said about the macro and micro economic factors underpinning the rise of the VUCA environment. In fact, recent analysis of the uncertainty in economics and financial markets from Peter Praet, member of the Executive Board of the European Central Bank, focused exclusively on the former, de facto ignoring the latter. Likewise, most recent comments from the Fed suggest that the U.S. monetary authorities are seeing key risks to the financial system as being politically driven, with macroeconomic risks rapidly abating.
Yet, things are far from rosy in the world of investment even when it comes to economic fundamentals. With political uncertainty reinforcing the economic ambiguity, we are witnessing a dramatic buildup of structural uncertainty in the markets. In historical comparatives terms, current fundamentals suggest a rising tide of imbalances in the financial assets valuations across the board, while the popular narrative among investors and analysts is reminiscent of the era when the heuristic of the “Great Moderation” dominated mainstream economic policy making and analysis.
Consider the U.S. Fed. At the end of 2015 and through the first couple of months of 2016, the U.S. Federal Reserve struck a relatively hawkish note when it came to forward policy guidance. Then, driven by weakening economic growth and rising political uncertainty, Yellen had to hold Fed rates untouched, barely managing to squeeze in a rate hike at the end of the year. The Fed started 2017 with clear signals that the markets can expect at least three rate hikes over the next 12 months. This time around, it appears that inflationary and growth dynamics may be on its side. But under the surface, the U.S. economic growth remains fragile, with just 1.9 percent annualized rate of real GDP expansion in 4Q 2016.
Unemployment is low, but underemployment is high and labor force participation is anemic. Much of the inflation uptick in 2016 and in the first months of 2017 is down to a shallow upside trend in energy prices and the rising cost of housing, not due to improving demand. In fact, disposable personal income growth, based on the latest data through January 2017, continues to underperform inflation, implying a deteriorating financial position of U.S. households.
On the policy side: the International Corporate Governance Network – a group of investors and fund managers with some USD26 trillion in assets under management – has explicitly warned the markets about the policy priorities of the current White House administration. In particular, the ICGN highlighted the policy environment rife with “potential short-termism” that can lead to poor policies structuring and longer-term damages from rushed policy and regulatory proposals, and opaque governance structures within the current administration.
The political uncertainty is fueling ambiguity about the overall direction of the economy, leaving the Fed in position as the sole underwriter of stability in the seas of turbulent macroeconomic waters. The first result was the Fed’s refusal to raise rates in February, and markets consensus shifting from expecting three rates hikes to two over 2017, and a drift in the next rates hike expectations from February-March to 2Q 2017. Then came early March, with markets’ sudden and dramatic repricing of the Fed hike expectations. The uncertain, ambiguous nature of the markets and investors’ expectations are now translating into rising volatility in monetary policy forecasts, tying the Fed’s hands into the next two to three months. This is a classic example of how VUCA environment works, transmitting general uncertainty into specific large-scale risks: suddenly, unexpectedly and sharply.
Beyond the rates hikes, even more mild policies toward reversion to monetary normalcy are hard to structure. For example, the Fed can start gradually shrinking its balance sheet by ending the practice of using principal repayments on maturing mortgages bonds to purchase new bonds and / or stopping the practice of rolling over maturing Treasuries. This move can take place before raising the official rates, since the policy was, in the first place, designed to help lower borrowing costs after the official rate already hit the zero bound. But, paralyzed by the political uncertainties and economic environment ambiguity, the Fed is reluctant to test the economy and the banks’ balance sheets through such a move.
Half of the problem is, the longer the Fed stays inactive, the larger the adverse impact of its balance sheet measures will be in the future, and the more likely it will severely impact ordinary households. Another half of the same story is that rising rates and tightening the Fed balance sheet today will most likely trigger the said crisis. The markets are, therefore, caught between a rock and a hard place: more accommodation from the monetary policy side is required to sustain current valuations, but more accommodation today implies a greater crisis and less predictable markets trends tomorrow. “Smart money” investors can do nothing else but take speculative positions and hedge against deeper uncertainty.
VUCA contagion across the Atlantic
Now, take the European markets view. Here too political uncertainty is driving a switch from traditional risk assessment scenarios toward the VUCA environment. Unlike in the U.S., however, this trend has been present for a number of years. Hence, the predictable spiking in markets’ perception of uncertainty in line with the re-emergence of the Greek crisis early this year. VStoxx options contracts volumes surged to historical highs at the end of February, with traders betting on increasing volatility in the European stocks going forward. But as with VIX, the actual VStoxx index is running close to its 2014 lows. Analysts attribute this to the investors buying hedges against the upcoming French elections.
In reality, there is much more than simple risk-hedging going on in Europe. In fact, VStoxx options moves have to be considered within a broader context of rising uncertainty. To see this, take the Sentix Euro-break up Index, which indirectly measures contagion risk across the euro area economies and directly reflects markets’ expectation of the probability of cross-euro area contagion risks from at least one member state exiting the euro area within the next 12 months. It is currently at the highs last witnessed at the peak of the 2012 sovereign debt crisis, with end-of-February reading at 47.61, up from the lows of 25 in mid-2016. Sentix-measured one-year probability of France exiting the euro area was at 8.25 percent – an eight-fold rise over the last seven months. Sentix Italy Index is currently at around 14 percent marker, down on an all-time high of just over 18 percent in 4Q 2016, but still well above previous historical highs.
All of the above stands are contrasted by a bull markets boom across European burses. Behavioral indices measuring the degree of overconfidence among financial investors in Europe are touching new two-year highs, just as the VUCA environment is coming into greater focus. Just as in the U.S., Euro area markets are currently combining seemingly contradictory environments of declining risk perceptions, rising uncertainty and ambiguity sentiment, booming asset valuations and weak economic fundamentals.
With a lag of about 18-24 months – judging by both the macroeconomic fundamentals and the financial sector performance data – the euro area is tracing out the U.S. trajectory.
In both the euro area and the U.S., the ongoing divergence between the risk valuations and the VUCA / uncertainty perceptions among the financial markets’ participants is creating an environment where assets valuations are increasingly becoming disconnected from the underlying macroeconomic, political and corporate balance-sheet realities. The end game of this development is a dramatic, albeit more ambiguous and less visible buildup in market imbalances. This translates into reduced effectiveness of the monetary policy as a tool for macroeconomic and financial markets stabilization. Powerless to normalize monetary policy and powerless to stimulate the real economic activity, monetary authorities on both sides of the Atlantic are forced into inaction, passively watching as asset values rise above the 2007-2008 crisis period relative valuations and heading toward the dot.com era ratios. Meanwhile, the current buildup of markets imbalances is starting to resemble a classic speculative bubble, where an increasing share of investors take short-term, liquid long positions in the markets, standing by to unwind these at the first sign of market weakness. In simple terms, the current VUCA environment is about as safe as an overloaded spring pushed against a slippery wedge.