The return of volatility means the good, bad and ugly will be revealed

For several years of steadily rising prices across all asset categories, investing was like bowling with gutter guards: Everyone showed solid scores in every frame. Monotonous gains pushed measured volatility to historic lows.

But volatility is surging again, mostly for reasons that will linger for years. Future investing score sheets are going to show who’s actually good at this game.

The primary change agent is the Federal Reserve, even if it just goes “one and done” with its tightening. Merely standing pat as the rest of the globe’s central banks keep up their liquidity injections will set off currency fireworks and continuing market spasms.

AUTOMATIC INVESTING

The effects will be amplified by two less talked-about changes. One is the rise of automatic investing: Trillions of dollars now move on autopilot, forced by formulas to react to every tick, and so magnifying trends. Simultaneously, we’ve lost critical financial shock absorbers that in the past distributed sudden selling pressures.

Fed monetary policies did what they were intended to do: raise asset prices. If you doubt for a moment that this was the real point, or that the game is now over, listen to former Dallas Fed President Dick Fisher, speaking in early January: “What the Fed did, and I was part of it, was front-loaded an enormous market rally in order to create a wealth effect … and an uncomfortable digestive period is likely now.”

The Fed has been playing less potent versions of this game since the days of the Greenspan put. As a result, price discipline has largely been, as Donald Trump might say, for losers. The return path to pricing off fundamentals is bound to be rocky and disappointing.

But the monetary policy story has many more characters than just our own Fed, for its clever tricks were learned by all the other central banks. Over time, extraordinary monetary policy has became not a last-ditch emergency tool of financial rescue, but rather a daily vitamin to buck up ailing stock markets, poor jobs numbers and sluggish economies. No need for fiscal policy, regulatory reform or entrepreneurial vigor. Just print and borrow.

The Fed understands the jig is up, that stimulus too is subject to the law of diminishing returns. Indeed, there’s a slow awakening that much of the excess liquidity flowed into overproduction, as it did in the oil patch, creating short-term jobs but long-term deflationary pressures.

Meantime, the party rages on for those other central bankers. Sovereign bonds with negative rates just passed the $5.5 trillion mark, says JPMorgan. Indeed, the Wall Street Journal computes that 20% of the global economy is now overseen by a central bank with negative rates. Dramatic stuff, for interest-rate wars are currency wars. And this central bank competition to capture share of global GDP certainly won’t end soon.

This Great Divergence — the Fed versus the Rest of the World — will remain a dominant theme of global finance for years. The dollar will likely continue to strengthen, with direct consequences for U.S. corporate earnings. Apple, for example, derives 2/3 of its revenues from overseas. And of course exports will be hit.

But many important consequences are more subtle and harder to predict. For example, China has been selling big chunks of Treasuries to raise the cash necessary for its market interventions, along with other sovereign holders. This can exert substantial upward pressure on our rates regardless of Fed action. Meantime, foreign issuers have raised $4 trillion or so of dollar-denominated debt, which is more expensive as their revenues have collapsed. Governments can’t ignore that.

The game theory reactions of each affected country’s policy makers will keep markets guessing. There is no playbook for what happens next. Asset prices are likely to kaleidoscope in highly unpredictable patterns for years to come. Oil is just Exhibit A.

AUTOMATIC ACCELERANTS

High-frequency trading dominates the exchanges; Commodity trading advisers race each other to follow trends; risk parity strategies instantaneously buy and sell massive asset baskets to maintain their volatility budgets; rebalancing formulas adjust enormous portfolios at least daily. Meanwhile, about $3 trillion is warehoused in exchange-traded funds that mechanically force money into, and then out of, preselected securities without regard to price, value or human judgment.

All this automatic investing amplifies price swings. For early examples, think back to the finance, tech or Japanese bubbles. Each time, the sector du jour came to dominate the related cap-weighted index (say the MSCI or S&P), attracting an ever greater percentage of new flows into the related investment vehicles: beautiful, self-reinforcing loops … until they burst.

But the passive investing tidal wave since the global financial crisis has taken these distortions to a new level. Consider: In 2006, the average stock included in the Russell traded at about a 12% premium to other small stocks. Today, that premium is 50%.

The point is that unintended and unforeseeable consequences inevitably arise when decisions are made by preset investment formulas. Now, imagine what can happen when we layer in all the warring algorithms with different motives, and especially ones specifically aiming to exploit other systems’ weaknesses, like ETFs’ pricing mechanics.

Or just look at last Aug. 24: 42% of U.S. equity ETFs experienced trading halts, compared with just eight S&P stocks. And one-fifth of equity ETFs saw price swings of 20% or more.

BROKEN BREAKERS

Of all the great contradictions of the past few years, none surpasses the Fed’s efforts to force risk-taking into our economic system — and forcibly remove it at the same time. As all that liquidity was being pumped in to promote investment, the Fed and Congress largely eliminated financial institutions’ abilities to mitigate its downside. Market making and prop desk activities have been shut down through express bans on proprietary trading and the imposition of prohibitive capital charges on financial asset inventories.

If you create more risk but limit the financial system’s ability to absorb the resulting volatility, what happens? Shocks are instantly transmitted into securities prices, triggering even greater shocks as investors and algorithms react to the large moves.

The primary concern here is the credit markets, in which the banks had served as the primary market makers. As they’ve decamped, the percentage of bonds owned by patient institutional holders has fallen dramatically, and the portion in “hot money” hands such as ETFs and mutual funds has soared. Very many of these new investors do not appreciate just how much interest-rate and duration risk they’re sitting on. Any shift to higher rates is likely to trigger selling pressure, which, without the traditional bank market makers in place, could easily spiral into serious price dislocations.

VOL’S BACK

As the Fed’s elixir is withdrawn over the next several years, we’ll be forced back into a world of fundamentally driven prices. Now each shaky step will be amplified by the tidal waves of reactions from both policy makers and all the new automatic investing systems and formulas. And the price moves won’t be cushioned by the traditional financial shock absorbers.

Volatility had a great vacation. It has returned to work refreshed and recharged.

Bob Rice is managing partner at Tangent Capital Partners.

Related Topics: Volatility