Reminder to Markets: JUMP CONDITIONS ARE DANGEROUS!

Tuesday 26th July 2016

  

Reminder to Markets: JUMP CONDITIONS ARE DANGEROUS!

ref:-  "Period of artificial calm distracts from potential for storms", INSIGHT by Mohamed El - Erian in the Financial Times, Markets and Investing

"Jump conditions" is a term borrowed from Physics and it's a great relief (to us, at least) that we don't need to have a full working knowledge of its original meaning. For market purposes however, it refers to a environment that could see a leap from one set of fundamental circumstances to another entirely different one without any smooth or gradual period of adjustment. Plainly, when this happens one could expect all kinds of commensurate market reactions, and some pretty violent ones too ..... that would only be logical, right?

Mr El - Erian is not only a contributor to the FT, Bloomberg and no doubt many other illustrious organs, he is also chief economic advisor to Allianz and in his role as chair of the Global Development Council has the ear of President Obama, no less. So when he has something to say it's generally worth a listen. On this occasion he's a mite concerned at the relaxed manner in which investors are dealing with a set of circumstances that are screaming out the potential for jump conditions. So far, financial markets have seemed content to treat some pretty seismic global events as though their effects are merely temporary and reversible blips. That may work in the short-term, says Mr El - Erian, but looking further ahead investors had better get themselves a smarter game-plan than that.

We know all about the Brexit vote, which did cause a sell-off in Sterling but provoked a remarkably muted reaction in both stock and bond markets. We could say the same thing about the escalation of Italian banking concerns, an attempted coup in Turkey and a number of terrorist atrocities. As if these events weren't momentous enough on their own, we should remember that they have taken place against a market background that is in itself way beyond what historically might be called normal, or indeed rational. Simultaneous record highs  for both stock and bond prices (and therefore lows for bond yields) does not normally compute, and nor does the fact that about a third of ALL global government debt is trading at yields below zero.

Nor does the future seem to scare investors. Apologies for repetition (what, again?), but October's Italian referendum could in theory (and taking a worst-case scenario) kick off a sequence of events that ends in a horrible mess for European politics ..... and then there's the US Presidential in November with Mr Trump now leading in many polls ...... and China's political and debt issues. And beyond all that, confidence that central banks can keep riding to the rescue of investors must surely come to an end at some point, mustn't it? For all those urging the central banks in Japan, Europe and China to experiment even further with monetary easing, there seems to be just as many convinced that monetary policy has reached its limit.

And yet, remarkably, an eerie sense of calmness rules. The Vix (CBOE Volatility Index which measures the implied volatility of S&P 500 options, and is revealingly known as "the Fear Index") is trading near recent lows below 13. By way of comparison, when China initiated a (comparatively minor) devaluation of the Yuan in August last year, it traded through 40.

You can usually find reasons for anything if you look hard enough. For example, liquidity injections ...... central bank stimulus and corporate cash being recycled through share buybacks, M & As etc. In many parts of the world economy, QE has soaked up the supply of government (and now corporate) debt and pushed prices higher and yields through the floor. In turn, the search for decent returns pushes other investors into taking on higher levels of exposure in equities. So yes, there are reasons all right ..... it's just that this correlation of equity and bond prices is highly unusual, to say the least. If you view it in a landscape of the huge political uncertainties we're about to face, Mr El - Erian worries that it is an explosive cocktail that would herald enormous financial volatility and those jump conditions we started with.

So, what to do? Bigger cash allocations, spread risk, prepare for volatility. To those who argue that the recent market calm improves the fundamentals that ultimately decide asset values, Mr El - Erain's response is that this is more likely to be the calm before the storm that will effect those fundamentals and asset values in precisely the opposite manner. Happy Days!