BackMarkets struggle to price in uncertainties
Investors would be well advised to incorporate higher uncertainty risk premiums in their investment calculations
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As investors position themselves for the final quarter of the year, markets have yet to price in the incertitude ahead. There are three reasons for this; all are related to the inherent difficulties of accurately determining risk premiums in this context of unusual economic, financial and political uncertainty.
1. The largest uncertainty is political.
In terms of systemic risk, Europe is the source of the greatest political uncertainty in coming months: The government of Prime Minister Theresa May in the UK will engage in tense negotiations with other European Union members over Brexit, even as the EU itself is beset by growing internal divisions on immigration. In addition, Italy will hold a referendum in December that could decide the fate of Prime Minister Matteo Renzi’s government. Meanwhile, Greece’s debt problems continue to fester, and the popularity of Chancellor Angela Merkel, the region’s most influential leader, is being challenged by the migrant crisis.
This unpredictability is particularly hard to price because it raises questions about long-standing tenets of regional economic interaction, including the institutions and rules governing cross-border movements of goods, labour and financial services.
The atypical US presidential election also exposes America’s economy to unusual political uncertainty. Although both candidates have signalled they wish to step back from the enthusiastic embrace of international trade that has strengthened the US’ economic role in the world, Donald Trump has gone a lot further by advocating punishing import tariffs on China and Mexico.
Until now, markets have essentially disregarded these uncertainties. Judging from history, political rhetoric, especially during heated election campaigns, does not always translate into action. Also, given the binary nature of the possible outcomes of some of these events (such as the Italian referendum), the appropriate risk premiums are even harder to determine.
2. Central banks have been the most effective repressors of volatility.
Through the use of an expanding set of unconventional measures, these institutions have been effective in boosting financial asset prices and repressing market volatility—directly, through large-scale asset purchases, and indirectly, by inducing investors to assume greater investment risks and companies to buy back stock.
Nonetheless, there is now a growing feeling that the effectiveness of such measures may be waning. For one, there is evidence of mounting concerns among some officials about the risk of engendering future financial instability (judging from the three dissenters at the recent Federal Open Market Committee meeting, this worry may be fuelling an active discussion within the Fed).
The questioning of policy is a lot more intense in Japan, where a growing number of indicators suggest that the central bank has suffered a significant blow to its policy effectiveness, and may risk becoming counterproductive.
Over the course of this quarter, investors will get more evidence about whether the centre of gravity within the Fed will end up tipping in favour of a rate hike, and whether further stimulus on the part of the Bank of Japan is indeed counterproductive. But the most important indicator will come from the European Central Bank, which will face a new set of challenges as it tries to shield markets from the region’s more complicated politics and its persistently sluggish economy.
3. The economics of protracted low growth are becoming more unpredictable.
Yet another set of unfavourable, though relatively small, revisions to the International Monetary Fund’s global economic projections are a reminder of the persistence of subdued growth in the advanced world and its negative spillover on to other countries.
The working assumption among most economists is that this mediocre performance can persist for years in a relatively stable fashion. I am not sure that prediction is correct because the longer this “new normal" persists—and it has been with us for about seven years—the more it seems to be creating the causes of its own destruction.
One of the big economic risks here is that households will join companies in becoming more cautious and will postpone some consumption decisions. Should this occur, it would contribute to an even bigger gap between subdued economic risk-taking and high financial market risk-taking—this would add an element of financial instability that the global economy has essentially been spared from for a few years.
These developments suggest greater market volatility in the final quarter of the year. The most sensitive segment will be foreign exchange, especially given the unusual economic and political uncertainties affecting trading relationships that have been deeply ingrained in economic and financial structures. But what starts in foreign exchange is likely to spread to equities, commodities, corporate bonds and, to a lesser extent, government bonds.
After enjoying a calm summer, markets should brace for greater volatility in the final quarter. Investors would be well advised to incorporate higher uncertainty risk premiums in their investment calculations, and favour lower volatility portfolio positioning and higher cash balances. By doing so, they can prepare better for a skewed risk-return market proposition. BLOOMBERG
Mohamed A. El-Erian is a Bloomberg View columnist.
Comments are welcome at views@livemint.com
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