As part of an extensive, cross-asset effort summarizing JPMorgan’s views in a 168-page report issued to commemorate a decade of the Lehman failure, and titled appropriately “Ten Years After the Global Financial Crisis: A Changed World”, JPMorgan head quant has published a section in which he lays out his thought on “What the next crisis will look like.”
To frequent readers of Kolanovic, the report is very similar to a similar effort he put together last October, in which he also previewed the “next crisis” – which he dubbed the Great Liquidity Crisis – and said would be defined by severe liquidity disruptions resulting from market developments since the last including i) decreased AUM of strategies that buy value assets; ii) Tail risk of private assets; iii) Increased AUM of strategies that sell on “autopilot”; iv) Liquidity-provision trends; v) Miscalculation of portfolio risk and vi) Valuation excesses.
Fast forward to today when despite his recently optimistic shift, Kolanovic reiterates many of the same underlying apocalyptic themes, making one wonder just how “tactical” his recent bullish bias has been.
Echoing what he said last October, Kolanovic writes that “the main attribute of the next crisis will likely be severe liquidity disruptions resulting from market developments since the last crisis”. A key feature of this market transformation, is the shift from active to passive investment, and the prevalence of trend-following investors and market makers, which “reduces the ability of the market to prevent large drawdowns.” In some bad news for the risk-parity crowd, Kolanovic writes that “in multi-asset portfolios, the ability of bonds to offset equity losses will be reduced” while PE firms won’t be spared either as private assets that are less frequently marked to market may understate the true risk exposure of portfolios. Combining these views with his core competency, market volatility, Kolanovic writes that “these factors may lead to a miscalculation of true risk due to a reliance on recent volatility as the main measure of portfolio risk.“
Which is an odd statement for Kolanovic to make considering the just two weeks ago, he was pushing the lack of market vol as a key support pillar for his continued bullish outlook on the market.
Cognitive dissonance aside, it is a breath of fresh air to glimpse a return of the old, “skeptical” Kolanovic, even if it is in the context of a strategic piece, while he maintains his bullish facade when it comes to his periodic tactical reports.
In any case, here is what Kolanovic thins the next crisis will looks like, as excerpted from the broader JPMorgan report.
* * *
What will the next crisis look like?
This year marks the 10th anniversary of the 2008 Global Financial Crisis (GFC) and also the 50th anniversary of the 1968 global protests. Currently, there are financial and social parallels to both of these events. Leading into the 2008 GFC, some financial institutions underwrote products with excessive leverage in real estate investments. The collapse of liquidity in these products impaired balance sheets, and governments backstopped the crisis. Soon enough governments themselves were propped by extraordinary monetary stimulus from central banks. Central banks purchased ~US$10 trillion of financial assets, mostly government obligations. This accommodation is now expected to reverse, starting meaningfully in 2019. Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis.
We will call this hypothetical crisis the “Great Liquidity Crisis” (GLC). The timing will largely be determined by the pace of central bank normalization, business cycle dynamics, and various idiosyncratic events such as escalation of trade war waged by the current U.S. administration. However, timing of this potential crisis is uncertain. This is similar to the 2008 GFC, when those that accurately predicted the nature of the GFC started doing so around 2006. We think the main attribute of the next crisis will be severe liquidity disruptions resulting from these market developments since the last crisis:
- Shift from Active to Passive Investment. We have highlighted the growth in passive investment through ETFs, indexation, swaps, and quant funds over the past decade, transforming equity market structure and trading volumes. For instance, as of May 2018, total ETF assets under management (AUM) reached US$5.0 trillion globally, up from US$0.8 trillion in 2008. We estimate that Indexed funds now account for 35-45% of equity AUM globally, while Quant Funds comprise an additional 15-20% of equity AUM. With active management declining to only one-third of equity AUM, we estimate that active single-name trading accounts for only ~10% of trading volume. We estimate ~90% of trading volume comes from Quant, Index, ETFs, and Options. The shift from active to passive asset management, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. Figure 1 illustrates the trend in passive assets, showing the growth of passive equity fund AUM as a % of total equity fund assets since 2005.
- The ~US$2 trillion rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption. Figure 2 highlights the inflows into passive equity funds since 2010 compared to outflows from active equity funds.
- Increased AUM of strategies that sell on “autopilot.” Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~US$1 trillion over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.
- Trends in liquidity provision. The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. In market making, this has been a shift from human market makers that are slower and often rely on valuations (reversion) to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day volatility, but it increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014, and August 2015. Figure 3 highlights the decline in S&P 500 e-mini futures market depth following a volatility spike, measured against VIX. S&P futures represent the largest liquidity pool for broad equity market exposure.
- Miscalculation of portfolio risk. Over the past two decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. This increases tail risk for multi-asset portfolios. An analogy is with the 2008 failure of endowment models that assumed Emerging Markets, Commodities, Real Estate, and other asset classes were not highly correlated to DM Equities. In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets). Another risk miscalculation is related to the use of volatility as the only measure of portfolio risk. Very expensive assets often have very low volatility, and despite the downside, risks are deemed perfectly safe by these models.
- Tail risk of private assets: Outflows from active value investors may be related to an increase in Private Assets (Private Equity, Real Estate, and Illiquid Credit holdings). Over the past two decades, pension fund allocations to public equity decreased by ~10%, and holdings of Private Assets increased by ~20%. Similar to public value assets, private assets draw performance from valuation discounts and liquidity risk premia. Private assets reduce day-to-day volatility of a portfolio but add liquidity-driven tail risk. Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis.
- Valuation excesses. Given the extended period of monetary accommodation, many assets are at the high end of their historical valuations. This is visible in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology and internet-related stocks. (Sign of excesses include multi-billion dollar valuations for smartphone apps or for initial cryptocurrency offerings that in many cases have very questionable value). Following the large U.S. fiscal stimulus, strong earnings growth reduced equity valuations to long-term average levels. Valuations came down in other pockets of excess such as Cryptocurrencies and several hyper growth stocks. Despite more reasonable valuations, equity markets may not hold up should monetary tightening continue, particularly if it is accompanied by toxic populism and business disruptive trade wars.
- Rise of populism, protectionism, and trade wars. While populism has been on the rise for several years, this year we have started to see its significant negative effect on financial markets as trade tensions have risen between the U.S. and numerous countries. The great risk of trade wars is their delayed impact. The combination of a delayed impact from rising interest rates and a disruption of global trade have the potential to become catalysts for the next market crisis and economic recession.
We believe that the next financial crisis will involve many of the features above, sparking the Great Liquidity Crisis (GLC), and addressing them on a portfolio level may mitigate their impact. It remains to be seen how governments and central banks will respond in the scenario of a great liquidity crisis. If the standard interest rate cutting and bond purchases do not suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor. Other “out of the box” solutions could include a negative income tax (one can call this “QE for labor”), progressive corporate tax, universal income, and others. To address growing pressure on labor from artificial intelligence, new taxes or settlements may be levied on technology companies (for instance, they may be required to pick up the social tab for labor destruction brought about by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.
The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, polarized, and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from liberal to alt-right movements to conspiracy theorists and agents of adversary foreign powers. In fact, many recent developments such as the U.S. presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis.
How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article “the death of equities” in 1979.
To summarized: financial apocalypse with a dash of civil war thrown in for good measure. But there’s time. Until then, don’t forget to BTFD.