After what were, in retrospect, very benign conditions for investors in 2017, volatility and risk have returned to markets. The question is not why markets are more volatile than last year, but why, given the length and strength of the current equity bull market and the political and economic backdrop, they are not more nervous still.
The list of things markets and investors might worry about is large. In the political arena, relationships between Russia and the West have deteriorated to a level not seen since the cold war. The US remains unpredictable. Protectionist rhetoric is rising, led by a White House that seems to disregard all standard economic theories and received wisdom on trade. And no one can say with confidence whether the ‘talks about talks’ with North Korea will lead to lasting peace or a resumption of more acute hostilities.
Europe continues to delay the completion of the banking union – a textbook case of failing to mend the roof while the sun is shining that the EU may come to regret in a future downturn. Brussels appears to have no answer to the challenge posed by illiberal regimes in Poland and Hungary, and Britain seems no closer to solving the several conundrums posed by Brexit.
The current positive state of the global economy belies some serious imbalances. President Trump’s extensive tax cuts will fuel a US economy that is already growing rapidly, with full employment and rising inflation. The prospect of growing twin deficits (budget deficit and current account deficit) is causing the dollar to weaken significantly. In Europe, Germany seems either unwilling or unable (or possibly both) to boost domestic consumption and curb its excessive current account surplus.
And yet, markets seem to take this all pretty much in their stride.
It is not unusual for bull markets to dismiss bad news. It is well known that ‘politics does not matter for markets, until it is the only thing that matters’. The same phenomenon can be observed with economic data – a bull market will shrug off poor economic data for some time before suddenly taking collective fright and turning the screens red.
Behavioural economists see this as a reflection of confirmation bias. This is the tendency for people to pay much more regard to information that confirms what they already believe than to information that challenges it. When the evidence is finally too much to ignore, people can react aggressively. This is the tipping point.
An interesting tipping point has been the change in public sentiment to international finance. There have always been aggressive operators in markets, with questionable morals and sharp practices. And while people generally disapproved, up until 2008 only a few of the most blatant offenders were caught and punished.
The financial crisis was the tipping point. Society’s response changed completely, from a general shrugging of the shoulders to revulsion and a determination to root out malpractice that finance has still not fully understood.
In the markets, confirmation bias means that investors who are positioned for markets to continue to do well will ignore adverse news until something, often in itself quite small, occurs to trigger a reappraisal. The weight of negative stories then cannot be ignored any longer and investors’ optimism is overwhelmed – at which point they can become suddenly and even unduly pessimistic and market sentiment swings round completely.
There have been few bull markets since the second world war that have lasted longer than the current one, and on some measurements none that has been as strong. This makes those holding assets more nervous, as they have bigger gains to protect, and more likely to scan the news looking for what might cause others to start the selling. So the likelihood of a breakdown, a tipping point, in the near future to medium term is increasing.
But that is all we can say. At this juncture we cannot predict what the final trigger will be, or when it will come. Quite possibly it will be something that is not even on people’s worry list at the moment. Nor can anyone say how severe the market reaction and reversal will be after we have passed the tipping point.
But that is the nature of tipping points.
John Nugée, a former Chief Manager of Reserves at the Bank of England.