Second Crash Warning From The IMF – This Time It"s About Vol

Another week, another warning regarding financial crash scenarios from those keen minds at the IMF.

In “Here Is The IMF’s Global Financial Crash Scenario” last week, we highlighted the institution’s surprisingly candid discussion hidden away in its latest Financial Stability Report “Rising Medium-Term Vulnerabilities Could Derail the Global Recovery"…or as we paraphrased the IMF’s “politically correct way of saying the financial system is on the verge of crashing”.

As we noted previously, in the section also called "Global Financial Dislocation Scenario" because "crash" sounds just a little too pedestrian, the IMF uses a DSGE model to project the current global financial situation, and ominously admits that "concerns about a continuing buildup in debt loads and overstretched asset valuations could have global economic repercussions" and - in modeling out the next crash, pardon "dislocation" - the IMF conducts a "scenario analysis" to illustrate how a repricing of risks could "lead to a rise in credit spreads and a fall in capital market and housing prices, derailing the economic recovery and undermining financial stability."

This week the IMF has gone a step further, courting the mainstream financial media to publicise its warning about the dangers of historically low volatility and related short volatility strategies.

As The FT reports, The International Monetary Fund has warned that the increasing use of exotic financial products tied to equity volatility by investors such as pension funds is creating unknown risks that could result in a severe shock to financial markets. In an interview with the Financial Times Tobias Adrian, director of the Monetary and Capital Markets Department of the IMF, said an increasing appetite for yield was driving investors to look for ways to boost income through complex instruments.

“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this,” he said.

It explains some of the short vol strategies that we’ve been expressing concern about for several years. To wit.

Mr Adrian’s warning comes amid increasing evidence that pension funds and insurance companies are venturing into riskier types of investments to gain income.

 

Some are also effectively writing insurance contracts against a market crash to pocket premiums. Last year the $14bn Hawaii Employees Retirement System said it was writing put options to boost its income, while other US pension schemes such as the South Carolina Retirement System Investment Commission and Illinois State Universities Retirement System have also hired outside managers to use option writing strategies. The IMF estimates that assets invested in volatility targeting strategies have risen to about $500bn, with this amount increasing by more than half over the past three years. Marko Kolanovic, head of macro, derivative and quantitative Strategies at JPMorgan, last month warned of “strategies that sell on ‘autopilot’”, and how risk management models that use volatility could be luring investors into taking on too much risk.

 

“Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models,” he wrote in a note to clients.

While we applaud this warning from the IMF, it’s absurdly belated and the short vol “horse” has long since bolted. Moreover, we think that the IMF is seriously under-estimating the magnitude of short vol risk in financial markets. Indeed, the IMF’s research department would do well to read the recent report from Artemis Capital Management which we drew investors’ attention to.

Artemis estimates that financial engineering strategies that are short vol, either explicitly or implicitly, amount to more than $2 trillion. However, both Artemis and the IMF are “on the same page” when it comes to what would unfold if there was a sustained spike in volatility. The FT continues...

The IMF believes that sustained low volatility increases incentives for investors to take on higher levels of leverage while causing risk models that use volatility as an important input to understate real levels of risk participants may be taking on.

“A sustained increase in volatility could then trigger a sell-off in the assets underlying these products, amplifying the shock to markets,” Mr Adrian said…

With equity implied volatility continuing to drop over the course of this year, investors who have bet that markets will remain tranquil have been rewarded. Yet the true quantity of complex products being sold that are linked to volatility of various assets is hard to ascertain due to such deals mostly being done in private. Regulators therefore find it difficult to map out the risks in the event of an unexpected market shock.

These Are The Top Geopolitical Risks According To The World"s Largest Asset Manager

Like many others, the world"s largest money manager with $5.9 trillion in (ETF) investments, BlackRock, is not too worried about a market which no matter what, promptly rebounds from any and every selloff, and seems to close at all time highs day after day as if by magic. To be sure, BlackRock"s employees are delighted: the less the volatility, and the higher the S&P goes, the more likely retail investors are to hand over their cash to BlackRock. So far so good. Still, not even Blackrock can state that after looking at this chart, which unveils unprecedented economic policy uncertainty at a time when equity uncertainty has never been lower...

... that everything is ok.

And it doesn"t: in a blog post by BlackRock"s Isabelle Mateos y Lago, Blackrock"s chief multi-asset strategist writes that while markets may be a sea of calm, geopolitics are anything but. As a result, the world"s biggest ETF administrator has its eyes on 10 geopolitical risks and is tracking their likelihood and potential market impact, as it wrote recently in the firm"s Global Investment Outlook Q4 2017.

The "world of risk" map below is a quick snapshot of all

Among the Top risks tracked by Blackrock are:

• North American trade negotiations


• Russia-NATO conflict


• South China Sea conflict


• US-China tensions


• Escalations in Syria and Iraq


• North Korea conflict


• Fragmentation in Europe


• Gulf conflicts

Of the risks listed above, which are the ones BlackRock is most worried about? According to Mateos y Lago, the top three right now: North American trade negotiations, a North Korea conflict and U.S.-China tensions, with the second and third particularly interrelated.

The details:

North American trade negotiations

The fourth round of North American Free Trade Agreement (NAFTA) renegotiations ended this week, with Mexico and Canada rejecting what they view as harsh U.S. proposals. Still, news reports did suggest apparent progress on less contentious parts of the agreement, and the negotiations aren’t over. The next round of talks are scheduled to take place in Mexico next month.

Our base case is that successful negotiations will be completed in early 2018. However, our hopes for this outcome have recently diminished given tough positions from U.S. negotiators and threatening rhetoric from U.S. President Donald Trump that has resulted in greater uncertainty. Market risks are biased to the downside given that a good outcome is priced in, in both Canadian and Mexican markets.

* * *

North Korea

We view North Korea’s missile and nuclear weapons program as a major threat to regional stability, U.S. security and nuclear non-proliferation. The possibility of armed conflict has risen, we believe, given North Korea’s missile launches over Japan, a nuclear test and an intense war of words. This has raised the chance of misstep or miscalculation, and we could see limited action such as the shooting down of missiles.

Yet we currently see a low probability of all-out war; the costs are too high on all sides. Instead, we expect the U.S. to intensify its “peaceful pressure” campaign, evident in imposing unilateral sanctions and leaning hard on China to participate. We see the crisis straining U.S.-China relations just as economic tensions are rising.

* * *

Deteriorating U.S.-China relations

We see frictions between the U.S. and China heating up over time. The countries risk falling into the “Thucydides Trap,” a term coined by Harvard scholar Graham Allison to describe clashes between rising powers and established ones. We see trade and market access disputes straining an increasingly competitive U.S.-China relationship in the long run, and believe markets have yet to factor in this gradual deterioration.

In the short term, tensions could rise if Chinese President Xi Jinping pursues an even more nationalistic agenda in the wake of the National People’s Congress. Economic tit for tats could lead to an erosion of relations—and have sector-specific effects.

U.S. military action against North Korea and/or an accidental clash in the South China Sea would deal a blow to the relationship, in our view, and hurt risk assets. But our base case is that the U.S. and China avoid these land mines in the short term, and try to use President Trump’s upcoming visit to emphasize cooperation.

Taking the above in context, what is BlackRocks recommendation for portfolios? The good news, according to the author, is that most geopolitical shocks have short-lived market impacts, except in regions directly affected. For those who wish to hedge, Blackrock recommends government bonds as useful diversifiers against volatility and equity market selloffs sparked by such shocks.

* * *

Meanwhile, in a separate observation, Rick Rieder, Blackrock"s global fixed income CIO pointed out another recurring, and ominous trend: "major central banks flooded global financial system with near $10T in liquidity since 2008, but now we’re beginning to unwind"

Indeed, major central banks flooded global financial system with near $10T in liquidity since 2008, but now we’re beginning to unwind pic.twitter.com/utyHoZZeco

— Rick Rieder (@RickRieder) October 19, 2017

... which leads to the question: "will others (foreign-exchange reserves, banks) step in to provide liquidity, so the transition doesn’t derail growth?"

Question is: will others (foreign-exchange reserves, banks) step in to provide liquidity, so the transition doesn’t derail growth? (3/4) pic.twitter.com/lKimYZRIVi

— Rick Rieder (@RickRieder) October 19, 2017

The answer: it all depends on China.

We think so; financial condition drivers (monetary base, USD, money multiplier) should be supportive, yet so much depends upon #China (4/4) pic.twitter.com/lr7kSKzsJO

— Rick Rieder (@RickRieder) October 19, 2017

Roubini: "Why Are Markets Ignoring Geopolitical Risks?"

Authored by Nourial Roubini via MarketWatch.com,

With Emmanuel Macron’s defeat of the right-wing populist Marine Le Pen in the French presidential election, the European Union and the euro have dodged a bullet. But geopolitical risks are continuing to proliferate.

The populist backlash against globalization in the West will not be stilled by Macron’s victory, and could still lead to protectionism, trade wars, and sharp restrictions to migration. If the forces of disintegration take hold, the United Kingdom’s withdrawal from the EU could eventually lead to a breakup of the EU — Macron or no Macron.

At the same time, Russia has maintained its aggressive behavior in the Baltics, the Balkans, Ukraine, and Syria. The Middle East still contains multiple near-failed states, such as Iraq, Yemen, Libya, and Lebanon. And the Sunni-Shia proxy wars between Saudi Arabia and Iran show no sign of ending.

In Asia, U.S. or North Korean brinkmanship could precipitate a military conflict on the Korean Peninsula. And China is continuing to engage in — and in some cases escalating — its territorial disputes with regional neighbors.

Despite these geopolitical risks, global financial markets have reached new heights. So it is worth asking if investors are underestimating the potential for one or more of these conflicts to trigger a more serious crisis, and what it would take to shock them out of their complacency if they are.

There are many explanations for why markets may be ignoring geopolitical risks.

For starters, even with much of the Middle East burning, there have been no oil-supply shocks or embargoes, and the shale-gas revolution in the United States has increased the supply of low-cost energy. During previous Middle East conflicts — such as the 1973 Yom Kippur War, Iran’s Islamic Revolution in 1979, and Iraq’s invasion of Kuwait in 1990 — oil-supply shocks caused global stagflation and sharp stock-market corrections.

A second explanation is that investors are extrapolating from previous shocks, such as the attacks of Sept. 11, 2001, when policy makers saved the day by backstopping the economy and financial markets with strong monetary and fiscal policy easing. These policies turned post-shock market corrections into buying opportunities, because the fall in asset prices was reversed in a matter of days or weeks.

Third, the countries that actually have experienced localized asset-market shocks — such as Russia and Ukraine after Russia’s annexation of Crimea and incursion into Eastern Ukraine in 2014 — are not large enough economically to affect U.S. or global financial markets.

Similarly, even as the U.K. pursues a “hard Brexit,” it still only accounts for around 2% of global GDP.

A fourth explanation is that the world has so far been spared from the tail risks associated with today’s geopolitical conflagrations. There has not yet been a direct military conflict between any major powers, nor have the EU or eurozone collapsed. President Donald Trump’s more radical, populist policies have been partly contained. And China’s economy has not yet suffered from a hard landing, which would create sociopolitical instability.

Moreover, markets have trouble pricing such black-swan events: “unknown unknowns” that are unlikely, but extremely costly. For example, the market couldn’t have predicted 9/11. And even if investors think that another major terrorist attack will come, they cannot know when.

A confrontation between the U.S. and North Korea could also turn into a black swan event, but this is a possibility that markets have happily ignored. One reason is that, notwithstanding Trump’s bluster, the U.S. has very few realistic military options: North Korea could use conventional weapons to wipe out Seoul and its surroundings, where almost half of South Korea’s population lives, were the U.S. to strike.

Investors may be assuming that even if a limited military exchange occurred, it would not escalate into a full-fledged war, and policy loosening could soften the blow on the economy and financial markets. In this scenario, as with 9/11, the initial market correction would end up being a buying opportunity.

But there are other possible scenarios, some of which could turn out to be black swans. Given the risks associated with direct military action, the U.S. is now alleged to be using cyber weapons to eliminate the North Korean nuclear threat against the U.S. mainland. This may explain why so many of North Korea’s missile tests have failed in recent months. But how will North Korea react to being militarily decapitated?

One answer is that it could launch a cyber attack of its own. North Korea’s cyber-warfare capabilities are considered to be just a notch below those of Russia and China, and the world got an early glimpse of them in 2014 when it hacked into Sony Pictures. A major North Korean cyber attack could disable or destroy parts of the U.S.’s critical infrastructure, and cause massive economic and financial damage.

That remains a risk even if the U.S. can sabotage North Korea’s entire industrial system and infrastructure.

Or, faced with disruption of its missile program and regime, North Korea could go low-tech, by sending a ship with a dirty bomb into the ports of Los Angeles or New York. An attack of this kind would most likely be very hard to monitor or stop.

So, while investors may be right to discount the risk of a conventional military conflict between the U.S. and North Korea, they also may be underestimating the threat of a true black-swan event, such as a disruptive cyberwar between the two countries or a dirty bomb attack against the U.S.

Would an escalation on the Korean Peninsula be an opportunity to “buy the dip,” or would it mark the beginning of a massive market meltdown? It is well known that markets can price the “risks” associated with a normal distribution of events that can be statistically estimated and measured.

But they have more trouble grappling with “Knightian uncertainty”: risk that cannot be calculated in probabilistic terms.