A while back I read a piece about political stability not being all it seems. It made the case that looks can be deceiving, and illustrated it something like this. Since 1945 Italy has had some 40 changes of prime minister. Saudi Arabia has had 6 rulers in the same period. North Korea has had 3. By that metric, Italy appears pretty unstable, while the other two look like oases of calm. But which keeps you up at night? For all the Machiavellian twists and turns in Italian politics, the political process has a way to reset the compression of the spring, to take out some of the tension every few years to stop it from popping, as the Italians turf out the incumbent and vote for a change. North Korea and Saudi Arabia on the other hand don’t have the mechanism, and need more and more pressure to keep it in place. The force underneath keeps on building though, the eventual reaction getting bigger. But that’s statistics for you – measured that way you get an answer on stability, but it’s probably the wrong one.
The S&P 500 trading range has dropped to the lowest levels in decades over the last few weeks, term premium in rates is close to zero, and the Dollar Index has barely changed the past 18 months. Inflation expectations are around the lowest of the post crisis period, and implied volatility is at the lows as well. On the face of it you’d think everything was calm. It isn’t. It feels to me like an incredibly unstable equilibrium currently; pressure is building up. This isn’t the first time we’ve written on it, and we certainly aren’t the only ones to do so. There is a ‘reach for yield’ of epic proportions going on currently, driven in no small way by continued ultra-low yields. It has intensified since the ECB and the BoJ sent bond yields out the curve through zero. Risk premiums are getting thinner and thinner, the price of safe cash flows is through the roof, and less safe ones are pretty high up the elevator as well. When I first started a wise old hand told me that much of what investors do can be broken down into exposure to a few things – term premium, carry, volatility selling, growth risk in equity/credit markets and maturity transformation. That’s as true today as it was then. The yield chase has reduced the compensation for taking each of these to razor thin levels. It makes sense to take risks when you are paid to do so – but at this point it is hard to justify. It is particularly concerning to me that from a macro perspective, it looks like the pendulum is finally starting to swing away from continued and ever increasing monetary policy – which is the driver of the trade – as either the policies are less effective and the negatives are higher than thought, output gaps are shrinking in others, or the central bankers call for fiscal action is finally being heeded.
Things that can’t be sustained, eventually are not. And when you are in a hole, the first thing you do is stop digging. The BoJ declined to give markets as much monetary methadone as they seemed to want. To our eye that’s a positive for the economy medium term as it doesn’t continue to slash the earnings power of the banks. It might not be politically palatable in the current climate, but it doesn’t make it any less true that an economy needs a healthy banking system to grow. Negative rates aren’t helping, and are arguably making things worse. The yield chase also encourages business to manufacture the bonds that people want, to lever the balance sheet and buy back stock. There is a stability argument here – high debt levels make businesses more fragile going into the next recession, as fixed costs increase and companies are increasing rollover risk.
In the US, the economy doesn’t seem as bad to us as the recent GDP prints would have you believe. When this turns, things are going to reprice in a hurry. To revisit the politics analogy, Italy has a high standard deviation but not much negative skew, North Korea the opposite. Yield chasing markets are seeing the stability of North Korea’s leadership and thinking things are stable – they see the low volatility and ignore the negative skew.