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Unnatural pressure

 Salomons Judgement

When risk-free interest rates have disappeared and investments are made based on misperceptions, it’s time to look for a place where pressures erupt. The plates are shifting.  Something is brewing.

Electrons start acting strange at absolute zero, my wife says. She is a physicist. I always argue that investors and managers do curious things when the interest rate is zero. At the presentation of the 2018 outlook I quoted Hyman Minsky, the once obscure and unknown economist whose name was on everybody’s lips after the outbreak of the credit crisis due to his observation that stability eventually destabilises.

A low interest rate, low volatility and low correlation lead to debt accumulation, which is not necessarily a problem unless the accumulation is based on misbeliefs or when the situation changes. Let’s say both are probably the case. I use the word ‘probably’ to give myself some room to manoeuvre.

Many investors consider the following assumptions to be true:

  • Monetary policy has no limits (print some extra money and the problem is solved);
  •  The put option of the central banks protects investors (whatever it takes when markets get into trouble);
  • There is a relentless search for yield (instead of accepting low interest rates, investors are taking more risks);
  • This time is different (no comment).

The assumptions have a mutual coherence, reinforce each other and to some extent explain the investor’s behaviours. You don’t have to agree totally, I don’t either. 

I am convinced that the market environment has changed this year. Central banks are raising the interest rates worldwide. The US government increasingly relies upon the capital markets to finance the expanding debts. Interest rates slowly rise, which doesn’t go unnoticed. In February, we saw a correction of investment products built around the idea that volatility will always remain low. Subsequently, a number of IPOs was cancelled. In recent weeks, emerging countries such as Argentina and Turkey got into trouble. The weak spots in the system are slowly becoming visible. That’s how capitalism works. These are the first cracks.

The capital costs increase for projects where misallocation of capital has occurred. Investors become more selective in what they want to finance. However, it doesn’t lead to a Minsky moment of instability yet. In that respect I have already pointed out the debt position of the business sector, where balance sheets have been expanded considerably in the past years. The Economist recently reminded us of that.

A second misallocation is in the financial system itself. It’s less visible and requires some more depth (Artemis). Not only private investigators bought products that depend on constantly low volatility, but institutional investors have also embraced such strategies. In many quantitative strategies, it’s implicitly built in. The buyback of one’s own shares – which is no different from selling volatility – is directly linked to the economy and completes the circle.

Interest rates are rising, and the central banks show no sign of backing down. Everything seems to be under control, but Minsky taught us to look for pressure points. In my field, you should never announce that something is about to happen and link a date to it. So, I won’t. For me, the canary in the coal mine is the connection between volatility and the interest rate on corporate bonds. It will feed on itself. Something is brewing. You have been warned …

The author

Roelof Salomons

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