A Disappearing Act

Plentiful money at near-zero cost has been the mood music of markets since the financial crisis. The result of this government-sponsored largesse? Suppressed volatility, greater risk taking and a potential misallocation of capital.

What happens to markets when financial conditions tighten and risks of a liquidity disappearing act pick up? Our main conclusions:

• Financial conditions have been the dominant driver of asset price returns since 2009 – especially in fixed income. Central bank policy has aimed to shift portfolios into riskier assets. Easy financial conditions are pushing pension funds, wealthy individuals and other investors into look-alike yield-seeking trades.
• The longer monetary policy suppresses uncertainty and underpins valuations,the bigger the eventual break. Recent sell-offs in biotech and other favoured sectors could be a preview of more volatile times ahead.
• Economies have grown more rate sensitive because debt levels are rising. G20 countries have racked up an additional $40 trillion in debt since August 2007. Household delevering has been more than offset by an explosion in sovereign debt. A rise in real economic activity typically helps fix the problem – but can be bad news for financial markets.
• Many investors are buying corporate bonds and other credit instruments at paltry and declining yields that offer decreasing compensation for risks: rising leverage and temporary bouts of illiquidity in the event of a market downturn. Any crunch would be exacerbated by sparse inventories of corporate bonds at broker-dealers – and their reluctance to take on risk.
• Equity and credit markets are joined at the hip. Cheap debt has led companies to extend maturities, raising the share and stability of cash flows accruing to equity holders. Equities are essentially long-dated options on cash flows. The higher the option’s price, the more sensitive it becomes to minor changes in interest rates.
• Liquidity measures are increasingly correlated with the VIX, the benchmark US equity volatility index. Like it or not, the world is hostage to US financial conditions – and this includes emerging markets (EM ). Their smaller financial systems, links to the US dollar and dependency on external financing magnify the impact of swings in capital flows.
• The US Federal Reserve is unlikely to raise rates until 2015 at the earliest, we believe, but volatility is set to rise from trough levels as the quantity of its stimulus wanes. This means portfolios today are more risky than they appear.
• Investors have to weigh the risk of getting caught out versus the risk of leaving the party too soon. Yet going against the crowd is difficult.
• Timing is everything – but predicting the exact timing of market turning points is tough. History suggests rising spread volatility, a spike in dispersion of US high yield returns from record low levels or an acceleration in US wage inflation would be canaries in the coal mine.

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