LONDON (Reuters Breakingviews) - What will cause the next market downturn? It takes a catalyst to trigger one, and other reagents to sustain it. Breakingviews runs through a few more and less obvious elements to watch.
(See Breakingviews graphic: Fuel for the next crisis? tmsnrt.rs/2juZgn8)
Central bankers like Janet Yellen at the Federal Reserve and Mark Carney at the Bank of England try not to surprise investors. That’s likely to be a tougher act to pull off in 2018.
Yellen, for one, will soon be replaced by President Donald Trump’s nominee as Fed chair, Jerome Powell. In addition to being an untested hand, he along with his counterparts may end up changing policy faster than markets expect. Carney, for example, has to keep an eye on UK consumer prices, with inflation running at 3.1 percent in the 12 months to November. Any sign that prices are suddenly on the rise could explode expectations of very gradual increases in interest rates.
Sharp market moves could be amplified by the Fed’s pre-programmed shrinking of its gargantuan $4.5 trillion balance sheet. After a decade of ultra-low rates, there could be huge amounts of exposure to rising interest rates, and in unexpected places.
The rapid growth and evolution of easy-to-use ETFs is a boon for investors. The vehicles hold some $4.4 trillion in assets, according to a recent EY survey, a more than 10-fold increase since 2005. The consultancy predicts 15 percent annual growth in the coming years.
That’s all well and good, but a few risks are creeping in. One is the widening range of what ETFs are trying to track. Bond funds, for example, are burgeoning. And increasingly providers are offering proxies for everything from certain hedge fund-like strategies – so-called smart beta – to the equivalent of leveraged bets against stock performance, like triple-short S&P 500 Index ETFs.
Some of these risk recreating a problem that bedeviled many banks and investment funds in the crisis of 2008-09: a liquidity mismatch between an ETF that can be traded during market hours and underlying assets that are, or become, illiquid, whether scarce bonds or volatile futures. Just as the failure of long-held beliefs about money-market funds exacerbated the crunch a decade ago, a loss of confidence in key characteristics of ETFs could worsen any future meltdown.
Big pension funds and other institutions have been delighted by buoyant equity markets. The FTSE All-World index, for example, was up 20 percent through Dec. 14, and the U.S. S&P 500 had gained 18 percent. But investors are also worried about the next downturn.
One fashionable notion is to put some cash into strategies variously dubbed crisis alpha, crisis risk offset (shortened to CRO) and similar clever monikers. These are supposed to perform positively in any big downturn. One strand of many such models is a strategy known as managed futures, which essentially follow momentum in a raft of liquid markets. These funds delivered big positive returns during the global financial crisis.
The danger, though, is that managed futures, and even more so other approaches with less history, could turn out like modern-day versions of portfolio insurance, which was supposed to minimize investors’ losses but ended up amplifying the market crash of October 1987. David Harding at Winton cautions that the success of his own managed-futures sector in recent downturns is not guaranteed to repeat in the next, and that superficially countercyclical strategies could end up going wrong, especially if too many investors have the same ideas.
To give these funds their due, they weren’t the main fuel for the conflagration of 2008-09 – that dubious honor goes to banks. Yet leverage and potentially crowded trades can create systemic risks, as Long-Term Capital Management demonstrated in 1998.
The largest hedge fund, Bridgewater Associates with $160 billion under management, has as its flagship a so-called risk-parity strategy. It’s designed to spread risk more or less equally across a range of asset types and possible market behaviors, using an element of leverage to help. The fund’s record and reputation are good, but it hasn’t been tested by a sustained bear market in bonds and it’s not immune to a set of circumstances that crater almost all its holdings at once, spreading fear among its legion clients.
Alternatively, large numbers of smaller funds – whose collective assets have doubled since the crisis to top $3 trillion, according to Hedge Fund Research – could end up being caught out by the same market moves, as computer-driven quant funds were in August 2007. Too many investors running for the exit at once is a recipe for market freefall.
It’s hard for a long-term investor to take seriously a holding that plunges nearly 20 percent in a day and then surges 80 percent to a record high just a week later. That’s what happened to bitcoin between late November and early December, though. For all the talk of its use as a currency along with the related blockchain technology, digital coinage is more than ever the domain of tech-savvy speculators. No wonder, with the value of bitcoin up around 17-fold in 2017 through Dec. 14.
The total value of outstanding bitcoin and rival ether reached over $350 billion, according to Coindesk. Much of that is on (virtual) paper, but it’s still symptomatic of booming financial markets combined with the growth of the digital economy. If hacks that exploit technological flaws or a sharp fall in demand crash the price, the fallout could prove contagious to the real world, too.
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