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Chris Leithner Letter for the month of 26 March-26 June 2017, titled, “Economic Policy Uncertainty and Financial Market Volatility: Yet another Example of Complacency in the Face of Risk?”
2016 Hedge Fund Letters
The Federal Reserve is a giant weapon that has no ammunition left. What I do worry about is: It was the Fed, the Fed, the Fed, the Fed for half of my tenure there [2005-2015]. Everybody was looking for the Fed to float all boats. In my opinion, they got lazy. Now we go back to fundamental analysis, the kind of work that used to be done, analysing whether or not a company truly on its own, is going to grow its bottom line and be priced accordingly, not expect the Fed tide to lift all boats. When the tide recedes we’re going to see who’s wearing a bathing suit and who’s not. We are beginning to see that.
Richard Fisher (Former President, Federal Reserve Bank of Dallas) Interview on CNBC (5 January 2016)
You know there’s this old line from Daniel Kahneman: we have to believe – we are hard-wired to believe – and so … it’s just as well to believe in something convenient. And I think the politicians find it convenient to believe that the central banks have it all under control. … But it’s not true, because what we have been doing is both losing efficacy over time, that is to say that the efficiency of the transmission mechanism seems to me to be getting less and less, while the impact of the associated unintended consequences, the side effects of monetary policy, are becoming more and more evident. In the end this is really going to cause us problems. And of all the unintended consequences I could list, lulling the governments into a false sense of security is probably the most important.
… Everything is fine until inflationary pressures or something else shocks up the interest rates. And the minute they go up, it becomes obvious that government debt service has gone high enough so they will have no recourse but to have the central bank finance still more. And when that happens the writing is on the wall, the currency collapses and the inflation becomes essentially uncontrollable. This is a highly non-linear process that can-not be captured by the econometric models that are in widespread use. They are essential-ly linear.
William R. White
OECD Chair Warns “Our Entire System Is Unstable”
Zero Hedge (10 February 2016)
Economic Policy Uncertainty and Financial Market Volatility: Yet another Example of Complacency in the Face of Risk?
In Leithner Letter 200-204 (26 July – 26 October 2016) I reasoned to the conclusion that stock markets in the U.S. – and, by implication, Australia – have become greatly and perhaps dangerously overvalued.1 Here I analyse two additional de-velopments: first, around the world economic policy has become highly unset-tled; second, and in sharp contrast, volatility in financial markets, and the fear that underpins it, seems implausibly low. Hence a key question – indeed, per-haps the key question for investors worthy of the name: can this combination of uncertainty, complacency and overvaluation persist indefinitely?
“I can’t recall a time in recent history when there was so much uncertainty,” re-ports David Taylor ( China-US Trade War the Single Biggest Economic Threat to Australia, ABC News, 10 January). “The world seems full of insecurity right now – no better represented than by the looming threat of a trade war between Aus-tralia’s largest and third-largest trading partners.” The New York Times agrees (see Davos Elite Fret about Inequality over Vintage Wine and Canapés, 18 January). It quotes an academic at Oxford University: “There’s never been a better time to be alive, and yet we feel so … anxious. So many people feel that this is one of the most dangerous times.” On the other hand, and as The Australian Financial Review (“The Certainty of Trump Uncertainty,” 3 February) notes, “one of the peculiar aspects of the current uncertainty in financial markets is the complete [sic] lack of volatility.” Justin Lahart (“What to Make of Market’s Calm during Political Storm,” The Wall Street Journal, 6 January 2017)2 elaborates:
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To judge from the news headlines, the past year has been full of dan-gerous surprises. [In the first quarter of 2016] a thicket of debt, emerg-ing market, dollar and commodity-price woes sent off recession warn-ings. Next, there was Britain’s vote to leave the European Union. And then [came] the upending of the U.S. political status quo in the election of Donald Trump. Indeed, as measured by an economic policy uncer-tainty index developed by economists Scott Baker, Nick Bloom and Steven Davis, this counts as a perilous period.
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}Yet the stock market … has been calmer than usual. … Last quarter, [it] posted its calmest performance in a decade. The decline in [the mar-ket’s actual] volatility has been matched by a decline in [implied future volatility as measured by] the Chicago Board Options Exchange Vola-tility Index, or VIX. The VIX measures how much options do protect against volatility cost; right now those costs are low, suggesting inves-tors aren’t worried about what is coming down the pike.
Why does the uncertainty of economic policy matter? As a rough rule, markets turn volatile when policy becomes uncertain; specifically, stocks’ prices and mar-kets’ returns usually tumble. Since 1900 in the U.S., for example, the greater is the month-on-month increase of policy uncertainty the lower is the monthly return of the S&P 500 Index. Indeed, during the ca. 40% of months when EPU rises most (i.e., in quintiles 4 and 5 of Figure 1) the market’s monthly return has been nega-tive.3
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Further, and as Figure 2 shows, the greater is EPU, the higher, on average, is the S&P 500’s volatility (VIX).4 The relationship between the market’s volatility and the S&P’s returns is complex (and thus hard to summarise in a simple graph); its direction, however, is negative.
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Why, given these long-term relationships, is economic policy uncertainty presently high and volatility low? Perhaps, Lahart muses, “stock market investors don’t care all that much about politics, and since the recent round of uncertainty is political in nature (as opposed to the uncertainty surrounding the 2008 financial crisis), it isn’t hitting stocks.” Yet participants in financial markets clearly do heed political developments: witness the sharp upward movement of stocks and the sagging prices of bonds in the U.S. and elsewhere since Mr Trump’s triumph at the polls. Why, then, although economic policy is apparently in flux, are finan-cial markets so calm?5 Lahart concludes: “investors aren’t looking much further than the end of their noses, and it won’t be until their noses run up against real trouble that they’re likely to react.”
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Just how indeterminate has economic policy become? The Donald is merely the lat-est in a series of “shocks.” “In the last five years,” notes CNBC ( Global Uncertainty About Economic Policy Is at Record Highs, 26 October 2016), “the global uncer-tainty index has been about 60% higher than in previous years, surpassing even the
