A risky business

The recent equity sell-off has focused investors’ attention on measures of market volatility, which have been abnormally low for much of the last four years. I did point out last summer that implied equity and bond market had fallen to all-time lows, and that there was a risk of a nasty surprise if investors believed that central banks would no longer continue to provide the unlimited support that they had hitherto (here). In the event, equity market volatility measures fell even further, bottoming out in November, whilst both the Fed and Bank of England since have raised interest rates.

Naturally, this raises the question, why now? And the truth is we don’t know. Many ex-post rationalisations have been offered but I suspect that markets had simply been living off fresh air for too long. It is thus possible that someone, somewhere simply placed a sell order that was picked up by algorithmic trading systems and triggered a widespread bout of selling. But nobody was really surprised that markets did correct sharply downwards, even if the magnitude of the correction caught many people out. Indeed, I pointed out last summer that “if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.”

At this stage, I do not have enough evidence to change my year ahead prediction that equities will finish 2018 up by 5-10% on year-end 2017 levels. But that view looks a little more shaky than it did five weeks ago. Whilst much attention focused on the fact that the correction in the S&P500 on Monday was the largest single daily points decline on record, it is only the 39^th biggest percentage decline on daily data back to 1980 (although that puts it well inside the top 0.5%). Slightly more worrying is the fact that exactly 10 years previously, on 5th February 2008, the S&P500 fell by 3.2% on the day – at the time, the 30^th biggest daily fall since 1980. And we all know what happened later that year …

Recent trends in volatility raise a number of key questions. First, is volatility mean reverting? If so, neither the extremely low levels of 2017 nor the elevated levels of today will be sustained. Second, if market volatility measures do move back towards more “normal” levels, how quickly is this likely to occur? And third, is it possible that the trend volatility level has changed (i.e. that investors risk appetite has changed)?

With regard to the first question, the post-1990 evidence does suggest that equity volatility is mean-reverting although it can diverge from the mean for a considerable period of time. On average since 1990, each period of over- or undervaluation relative to the mean lasted for 17 months, which suggests that the period of adjustment is relatively slow. With regard to the second issue, in 88% of cases since 1990 the VIX was within one standard deviation of the mean (although on only 38% of occasions was it within half a standard deviation). One standard deviation represents a 7-point move in the VIX which is relatively tolerable. It is only when we see the kinds of spikes associated with the bursting of the tech bubble between 1999 and 2002, or the post-crisis period of 2008-09, would high equity volatility threaten to derail the markets.

However, there is a risk that an extended period of low volatility sows the seeds for a period of higher vol. Lower volatility during periods of economic upswing tends to result in higher risk taking and excessive leverage, with the result that even small price declines can force investors to dump asset holdings, depressing prices further and generating higher volatility. This triggers a second round of price declines and volatility spikes which could turn into a self-reinforcing spiral. But as it currently stands, despite the sharp spike in equity volatility in early February, the forward vol curve is pricing in a decline back to levels close to the long-run average over a five month horizon (chart). This downward sloping volatility curve is not indicative of a market which is expecting a significant change in risk conditions.

As for the third question of whether there has been a shift in the trend level of the VIX, and therefore a shift in investor risk tolerance, the jury is still out. We will probably only know after a prolonged period of tighter monetary policy. The most four dangerous words in finance are “this time it’s different.” Any data series which shows strong mean-reverting trends should be treated as such until we have overwhelming evidence to the contrary.

All in all, I am inclined to treat the current trends in markets as some of the air coming out of the bubble rather than as the beginning of a more prolonged sell-off. As many people have pointed out, the fundamental factors which drove markets higher in the first place – strengthening growth and the impact of US tax cuts on corporate earnings – remain in play. But the spike in volatility acts as a reminder that markets are like wild animals: they can act unpredictably and you can never tame them, so you have to act cautiously to avoid getting your face ripped off.

Crisis? What crisis?

David Miles, former Bank of England MPC member and now professor of economics at Imperial College, this week issued a clear rebuttal (here) of Andy Haldane’s charge that economics is in “crisis” (here). Miles makes the point very bluntly: “If existing economic theory told us that such events should be predictable, then maybe there is a crisis. But it is obvious that economics says no such thing … In fact, to the extent that economics says anything about the timing of such events it is that they are virtually impossible to predict; impossible to predict, but most definitely not impossible events.” 

He then goes on to point out that basic economics, in which organisations act in their own best interests, explained perfectly well why the financial crisis happened. In a world in which banks knew that they would face only a limited liability for the losses they created, and where the tax system favoured debt over equity, they had every incentive to increase their leverage. He also reminded us that there is a whole literature on market failure and that economists have won the highest academic honours for “exploring the ways in which free market outcomes can sometimes generate poor results.”

Indeed, when you think about it, the record of economists in predicting economic shocks is no worse than that of seismologists in predicting earthquakes. There are various warning indicators which signal that an earthquake may be imminent but scientists cannot pinpoint accurately when they will happen, and certainly not months or years in advance. Or, as Miles put it, “any criticism of “economics” that rests on its failure to predict the crisis is no more plausible than the idea that statistical theory needs to be rewritten because mathematicians have a poor record at predicting winning lottery ticket numbers.”

As I have noted on numerous previous occasions, economics is not a predictive discipline so we are forced to do the best we can in order to meet the demand for predictions of future economic activity. And unfortunately, despite the best efforts of former UK Chancellor Gordon Brown to abolish boom and bust, we are faced with the problem of simultaneously trying to predict the amplitude and frequency of an economic cycle which is not regular. It can shift abruptly, which leads to structural breaks in our model-based forecasts. If there is a “crisis” in economics it is that too much mainstream policy analysis focuses on the central case outcome, which becomes a binary choice as to whether the forecast in question was attained. This raises a question of whether a forecast for 2% GDP growth in any given year is “wrong” if it turns out to be 2.2%. It is a pointless exercise to strive for that sort of precision, which raises the question of how far away we are allowed to be from the central case before our prediction is deemed “wrong”. 

In fairness the likes of the BoE have long maintained that it is the distribution of risks around the central case which is important (and many others are now catching on). By defining the probability distribution around the central case we then have some idea of the plausible range of outcomes. But we have to accept that economics cannot predict the point at which the steady state switches from one condition to another, in much the same way that quantum physicists cannot determine with any precision the degree to which certain pairs of physical properties of a particle can be known. In other words, we cannot forecast structural shifts.

But one of the things that economics can do is to figure out how behaviour will change once the structural shift has occurred. Forecasters may not have incorporated the crash of 2008 into their central case (I will expound on some of the reasons why on another occasion) but expectations adjusted quite quickly thereafter. It was treated as a structural break with profound consequences for near-term growth, and consensus GDP growth numbers were revised down sharply thereafter, as indeed were expectations for central bank policy rates. Seismologists may not always be able to predict when the earthquake will strike but they know what the consequences will be when they do