The Unseen Dominoes
While low levels of implied volatility may comfort investors for the moment, it seems prudent to contemplate current factors that run counter to low levels of implied volatility:
Debt Outstanding: The total amount of U.S. debt outstanding, including Federal, personal and corporate debt, is greater than $60 trillion and over three times U.S. GDP. More concerning, much of this debt is unproductive as it has not been employed towards productive investments which generate economic growth to service and retire the debt. Debt used solely for consumption, as has largely been the case, allows for the purchase of more goods and services today that otherwise would have been consumed in the future. This leaves a consumption void tomorrow, as demand is satisfied and marginal consumption is restricted by debt payments.
“To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about.” Friedrich Hayek – Monetary Theory and the Trade Cycle
Interest Rates: Interest rates have been on a 35-year path lower. This is partially the result of decades of demand-focused monetary policy designed to incentivize debt-fueled consumption. With interest rates at unprecedented low levels and a limited ability for many to continue borrowing, the marginal benefit of lower interest rates is minimal. Additionally, investors are being forced to take outsized risks due to paltry returns offered by most fixed income securities.
Productivity: Productivity growth in the U.S. and most developed economies has slowed sharply from prior decades and in many cases has begun to decline. Without productivity growth, economic growth can only occur with increased debt and/or favorable demographics. Given poor demographics and record debt levels, relying on either is a highly questionable strategy.
New York Times author and economist Paul Krugman said: “productivity isn’t everything, but in the long run, it’s almost everything.”
Economic Trends: GDP growth in the U.S. has been in secular decline for over forty years. The rate of real economic growth is projected to be below 2% for the years ahead. This assumes the productivity, demographic, and debt landscape referenced above. Secular GDP per capita, a better measure of true output, is growing well below 1% annually and could decline in the years ahead.
Trump, Brexit, and Nationalism: Donald Trump, BREXIT and a growing worldwide nationalist movement raises concerns that global trade may become compromised. The Great Depression was, in part, due to a reduction in global trade as a result of protectionist actions. See Hoover’s Folly for more information.
China: The significant growth of China has played an outsized role in supporting global growth over the past fifteen years. The combination of cheap labor and a surge in debt is rapidly losing its effectiveness in China. Massive debt loads, rapidly declining productivity growth and competition is resulting in financial instability.
Rising Social Instability: Donald Trump, Bernie Sanders, BREXIT and other recent events serve as clear signals that voters are demanding change. The financial effects of consumerism are finally forcing people to bear an unacceptable weight. Social instability is on the rise as can be attested to by the recent riots at Berkley, the post inauguration women’s march on Washington, and racially oriented riots in Baltimore and St. Louis. While these events have different themes, causes and flag bearers, they are indicative of inequality.
The VIX
The prolonged monetary exertions of the Federal Reserve and global central banks have put investors into a complacent trance. Implied volatility appears tame but a regime shift, when it arrives, will test even the most seasoned managers.
Volatility has not been mastered. The powerful forces that have suppressed it will turn, and the dormant but still present fundamental forces that few seem to consider will not fade away. The recognition of reality may occur slowly and provide watchful investors ample warning. However, the vast chasm that lies between reality and implied risk could make such a turn explosive and will certainly catch the unprepared off-guard.
Summary
Fixing the world’s economic and financial problems will be arduous and steps taken to date have done nothing to abrogate those issues. Durable solutions require time, discipline, sacrifice and a return to sound fiscal and monetary policy. Throughout the last 30 years, mounting economic problems have been consistently ignored. The overriding goal of economic policy makers has been to keep near-term economic growth on par with the seemingly arbitrary goals of the day. Economic policy has focused on immediate gratification and avoidance of pain at the expense of long-term economic health. This adolescent logic stimulates short-term growth as desired, but more importantly, it fosters boom-bust cycles and long term instability.
Successful investors understand that optimism, momentum and hope, the first order movements, the emotions that currently fill the media and Twitter-sphere, are most responsible for driving prices on a day-to-day basis. There is no doubt that such animal spirits could easily send the market even higher. That said, investors would be well-advised to devote significant time toward considering the multiple order effects. It is those effects, the emblematic line of forgotten dominoes, which will ultimately drive prices. When the entirety of the current situation begins to more fully reveal itself, investors are likely to find that the difference between esoteric measures of implied volatility and their very tangible perception of reality could not be more different.
Get more of my thoughts and research over at 720Global. Thanks for reading.
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Twitter: @michaellebowitz
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
