Roro and Broken Markets
April 21 – Financial Times (Bryce Elder): “Markets are broken. Accepted investment wisdom has been overturned and the basic tenets of value and diversification no longer work. The financial crisis put the market into a volatile ‘risk on, risk off’ – or Roro – mode for which there is no cure. For many investors, this has made stockpicking seemingly an impossible task. Markets once responded to their fundamentals. Now, disparate assets have a much greater tendency to move together, individual characteristics lost. Trusted strategies such as relative value and currency carry trades are nearly useless, overwhelmed by daily market-wide volatility.”
The above is the introductory paragraph to an FT article, “‘Roro’ Reduces Trading to Bets on Black or Red.” Market players have by now become seasoned to the “risk on, risk off” (“Roro”) dynamic. Yet few are willing to concede (publically) that global markets are indeed broken – and likely irreparably. As highlighted in the article, this trend began to take root with the unfolding financial crisis back in 2007. The investing world then turned essentially bimodal with the Lehman Brothers collapse. Approaching four years later, the market landscape is providing no indication that it has even the slightest inclination to return to normal. This is a critical issue.
From HSBC strategist Stacy Williams (noted by the FT): “Assets now behave as either risky assets or safe havens, and their own fundamentals are secondary. In a world where most asset classes are synchronised, it becomes very difficult to achieve diversification. It also means that since most individual assets are dominated by a common price component, it becomes increasingly futile to invest in them based on their usual fundamentals.”
Most investment professionals appreciate that there have been fundamental changes in the marketplace, although there are disparate views as to the root cause. From the FT: “The [post-Lehman] uncertainty helped turn investing bimodal, where every price has been contaminated by systemic risk. Everything became a bet on whether we were closer to a global recovery or to deeper crisis.”
Few would disagree that extraordinary uncertainty plays an integral role. I would underscore, however, that the epicenter of this dilemma of uncertainty lies within the realm of policymaking. I take exception to the reasonable notion that market prices have been "contaminated by systemic risk.” Instead, contamination is predominantly a phenomenon associated with ongoing and, indeed, escalating government market interventions. I would argue that persistently elevated systemic risk is a product of unrelenting policy “activism.” Moreover, market faith in ever grander government responses is the only thing holding a quite problematic risk off – “little ro” - at bay. Those that believe market uncertainties are predominantly a product of systemic stress see these risks subsiding naturally over time. I believe today’s untenable policymaking course is the true culprit – and resolution will come with a major global crisis.
The essence of “Roro” boils down to red or black market outcome bets based chiefly on three related factors: First, there is the timing of policymaker interventions. Second, is the nature and scope of policy responses. And, third, the expected near-term consequences of policy measures both from market and economic perspectives. The interplay of these three factors and how it plays upon market perceptions tend to be complex and, at times, mercurial. For example, as systemic risk becomes a concern the marketplace will tend to place bets in a rather measured and straightforward manner. But as market stress begins to elevate, the timing of policy moves becomes increasingly critical and the interplay with the market perceptions more complex.
A delay in a policy pronouncement (additional QE, for example) might create acute risk that market conditions rapidly deteriorate. A day or two can make a huge difference. At the core of the problem, a highly leveraged and speculative marketplace creates a tenuous – and policy intervention-dependent – backdrop. And as systemic risk and the scope of wagers rise in concert, the divergences between possible outcomes becomes increasingly extreme (i.e. the volume of speculation and systemic risk hedging directly raises the probabilities for both major upside and downside market outcomes).
Importantly, however, a major escalation of systemic stress (think Q4 2012 Europe and the LTRO) would most likely be met eventually with an overwhelming policy response (“bazooka” or the Bernanke/Draghi put), setting the stage for a major reversal of bearish bets and systemic hedges. Policy dithering and delays on the one hand create significant market risk (and heightened hedging/betting), yet at the same time also increase the probability for the type of panicked policymaker response sure to incite a dramatic market reversal (short squeeze, upside dislocation and intense speculation). As such, the great “Roro” trade essentially becomes a calculus on the interplay between market fragility, “activist” policymaking and market technicals (especially with respect to bearish/hedging positioning).
Mr. Elder’s provocative article also addresses how investors might best approach “risk on, risk off”: “The most obvious way to deal with Roro is not to fight it. Pick a side, boom or bust, and build a portfolio to give the cleanest possible exposure to the trade. The investor still has to choose the correct side – but at least their investment is straightforward and sincere.” True enough, and I do appreciate the use of the word “sincere.” But in such an uncertain and volatile world, most market professionals shy away from such potentially career-shortening wagers.
Which leaves us with the alternative: “Another option is to seek out an investment strategy that still works. Momentum investing – in effect, buying the winners and selling the losers – is a method that HSBC analysts highlight as having been largely impervious to the risk trade. To chase a trend aims to harvest small but systematic mispricing of assets, and there is no reason to suppose these anomalies would disappear in bimodal markets… (In this context, the growth of high-frequency trading since the start of the crisis is unlikely to be coincidental.)”
So, essentially, the marketplace faces a single decision: Make a big red or black bet or, if you have a functioning brain, do what “still works” – “momentum investing.” And this does a respectable job of explaining why markets have evolved into pathological trend-following speculative Bubbles – everywhere - and why hedge funds, ETFs and other market wagering vehicles proliferate. And the bigger the Bubbles inflate, the greater the systemic fragilities – and the more confident the speculators become that policymakers have no alternative than to continue delivering the goods. And, at this point, the powerful sophisticated players just love that “Roro” holds policymakers securely hostage.
Europe is an unmitigated disaster. And, increasingly, there is recognition that true structural reform is the region’s only real hope. The Wall Street Journal’s Wednesday op-ed page had an exceptional editorial, “Europe’s Phony Growth Debate.”
From the WSJ: “Growth or austerity? That’s the choice facing Europe these days—or so the Keynesian consensus keeps saying. According to this view, which has dominated world economic councils since the 2008 crisis began, ‘growth’ is mainly a function of government spending. Spend more and you’re for growth, even if a country raises taxes to pay for the spending. But dare to cut spending as the Germans suggest, and you’re for austerity and thus opposed to growth. This is a nonsense debate that misconstrues the real sources of economic prosperity and helps explain Europe’s current mess. The real debate ought to be over which policies best produce growth.”
It’s increasingly obvious that the so-called “Keynesian” (I think Keynes would be appalled) approach of massive fiscal deficits and monetary inflation is an abject failure. Policies have only delayed necessary adjustments, while fomenting acute financial, economic and political risks. Much of Europe remains in desperate need of deep structural adjustment, and it’s a travesty that years of government profligacy have left little capacity to assist in financing reform measures. As the Journal article noted, labor, tax, political and monetary reform would work to promote sound investment, capital formation and more productive and flexible economic systems.
But here’s my rub. Deep economic reforms tend to be arduous and, at least initially, destabilizing affairs. They unfold – and enrich societies - over years – while “Roro” thinks in terms of market hours, days and weeks. Reform and “Roro” seem incompatible – perhaps adversarial. To improve economic structures will require enormous private-sector investment. “Roro,” with its fixation on policymaking, financial speculation and inflating Bubbles, has precariously set its course in the opposite direction. “Roro” is incentivized by short-term speculative market returns, especially leveraged spread trades and other so-called price anomaly “arbitrage.” “Roro” is antagonistic to long-term investing and real economic returns achieved through investment in capital formation. “Roro,” a creature of financial and economic imbalances, exacerbates excesses and acts as an adversary to economic prosperity.
Meaningful economic reform is bolstered by confidence that things are moving on the right path – and it’s stopped dead in its tracks from fear of looming calamity. “Roro” foments only greater uncertainty and trepidation. And I am convinced that monetary instability is a powerful reform inhibitor. Reform is instead supported by trust in the course of policymaking and the stability of the political process more generally. I would argue that “activist” policymaking and its “Roro” offspring are contributing to a dangerous distrust in government, institutions and free market Capitalism more generally. I see “Roro” as antidemocratic, creating risks of destabilizing electoral backlashes in democracies worldwide. Increasingly, frustrated Europeans see speculators and “international finance” as unethically siphoning away vital resources.
It is approaching 20 years since James Carville famously quipped that he would “…want to come back as the bond market. You can intimidate everyone.” In the late-nineties, many (including Paul Volcker) worried that the global economy had become dangerously dependent upon a speculative U.S. stock market. If one takes a step back and examines the scope of global debt markets and the nature of speculative excess that today commands global securities markets, one is forgiven for taking a quite pessimistic view. Crisis repeatedly followed by bigger crisis – greater government control over everything, and only talk of true reform. Amazingly, the amount of debt just continues to mushroom – while the scope of global leveraged speculation runs unchecked. The unwieldy interplay between uncontrolled debt expansion and epic financial speculation some years back enticed global policymakers down a very precarious path. It is within this context that we should contemplate “Roro.”
Well, just another week at the casino. A Socialist took a giant leap toward the French Presidency. Spanish unemployment jumped to a near-record, a depressionary 24.4%, and S&P downgraded Spain’s debt two notches to near junk status. The Dutch government became the latest political casualty. The United Kingdom fell into double-dip recession, as economic data throughout the region has turned almost universally dismal. But with rattled officials rather abruptly now espousing more growth measures and less austerity, European markets enjoyed a bit of a breather.
Here at home, Chairman Bernanke assured the market master that the Fed was ready to inject another round of quantitative easing when demanded, while deflecting criticism from Paul Krugman that the Fed hasn’t been printing enough. U.S. stocks rallied (although with less than confidence-inspiring market underpinnings), with “Roro” mo players and bullish speculators further emboldened. This, of course, ensures that when “little ro” inevitably emerges on the scene he’ll pose a giant problem. As the Financial Times’ Bryce Elder astutely noted, “Roro – mode for which there is no cure.”
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