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At the end of each of his ’Money Stuff’ newsletters, Bloomberg columnist Matt Levine devotes a few lines to a theme with the leitmotif, “People are worried…”, of which “People are worried about unicorns” and “People are worried about bond market liquidity” have been among my favourites. I don’t know when it first came up, but there appears to be a recent addition to the list of things that people are worried about, namely “People are worried that people aren’t worried enough”. But that isn’t the end of the story, since there also seem to be people who worry that people are too worried that people aren’t worried enough, as Levine remarked in a recent issue from early August. Oh boy - there is some serious third-degree worrying going on.
So what is this all about? It is about the weird dichotomy that has persisted for a while now between the performance of the stock market (and more or less any other asset class) on the one hand, which has been ’up, up, up’, and the perceived health of the real economy, which appears to be somewhat ’meh’, on the other. As stock markets kept achieving new highs whilst recovering from their 2008 lows, economic growth – in particular in developed countries - has been disappointingly sluggish. As a result, there has been a growing choir of Cassandras and gold bugs abusing our ears with their song of impending doom and gloom and claiming that the end (which according to them should have already come about in 2008, but got postponed due to central bank and state intervention) is nigh – now, finally and for real. I must admit they have some good points.
Since the financial crisis, global government and private debt have significantly outpaced GDP growth: the world has never been as leveraged as it is now. China, where total debt now runs at over 300% of GDP, is a particularly worrisome case in point. Despite recent signs of growth Europe still looks fragile, and you don’t need to search hard to find real estate bubbles all across the globe (Australia, Canada, Denmark, Sweden are hot candidates from what I can gather). On top of all of this the world community faces a number of geopolitical situations which could lead to serious disaster. Doomsday prophets point to all of these risks and contrast them with the fact that the VIX, the index tracking the volatility implied by options on the S&P 500 traded at the CBOE and commonly referred to as the ’fear gauge’, is currently standing at 10.3%.
This level is only marginally higher than its all-time low of 9.36% on 21 July this year, and below where it sat in 2006 (c. 11.30%) shortly before the US housing market started to crumble, in response to which the VIX shot up to 44%. Add to the low levels of volatility the fact that High-Yield CDS spreads, as measured by the iTraxx XOVER index, are currently hovering around 230bps (down from over 750bps only 5 years ago) and that the Cyclically Adjusted Price to Earnings Ratio (the “Shiller PE”) has surpassed its 2007 readings. In summary: in spite of all these things that could go horribly wrong, valuations are lofty and market participants seem relaxed (including Fed chair Yellen, who doesn’t believe she will see another financial crisis during her lifetime). This phenomenon has been dubbed “peak complacency”, and it is exactly this complacency that people worry about, thinking it is the harbinger of the next downturn.
In order to give the whole argument a scientific spin, the Financial Instability Hypothesis according to Minsky is frequently invoked. Hyman Minsky, an American economist, was little known to many until the Global Financial Crisis inadvertently brought his ideas into the spotlight of economic discourse. At the core of his hypothesis lies the premise that financial stability leads to instability, as borrowers become increasingly speculative in their financing activities the longer the business cycle goes. This eventually leads to the point where the only way for them to service their debts is by way of asset appreciation.
At the end of this debt binge stands the ‘Minsky Moment’ – the inevitable reckoning when asset bubbles pop and the “Ponzi financing” (this is indeed a Minsky term) comes to an abrupt halt. As borrowers default and debts go bad, the financial system implodes. This, in a nutshell, is Minsky and what happened back in 2007. People worry it is going to happen again.
I don’t think there is any doubt, that we are in what Minsky coined the “speculative” stage, where debts get rolled rather than repaid. This has been going on for a while now, and while leverage generally is high, my personal impression is that we haven’t crossed the Rubicon yet. Our clients here at JCRA employ leverage to enhance returns, and to me there seems to be a lot of awareness that we are potentially very late in the cycle. PE sponsors build a recession scenario into the sensitivity analysis of their business cases and the covenant headroom we see on transactions allows for some margin for error. Whatever Minsky meant by “Ponzi financing”, I don’t believe we are there yet, which is why I am not running for the hills to safeguard myself from yet another 2007 Minsky Moment.
More generally, I do not sense the euphoria or mania that is said to go along with asset bubbles when they are just about to blow up. If you are looking for such a thing, you may want to consider crypto currencies (too many people seem to be too excited about these) or tech start-ups (people buying non-voting shares in Snap Inc. suggests to me that this sector may have indeed entered the gates to crazy town), which may cost some investors some money, but on their own shouldn’t bring down the entire financial system.
So, am I complacent? No, there are real risks out there that have the potential to do significant damage (including monetary policy mistakes), but to me it seems that most investors are very well aware of looming dangers and the implications of the elevated valuations we are observing across asset classes. Prices are high because there is too much money chasing too few investment opportunities, not because people are excessively sanguine about future growth prospects. This may not sound very reassuring, but it is a lot better than blind bullishness. So while some people are worried that people don’t worry enough, perhaps in aggregate, we worry just about the right amount.
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