Out of sight, out of mind

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Articles by Jamie

Jamie Dannhauser

Economist

11 April 2024

Stability breeds instability. With those three words, Hyman Minsky illuminated something fundamental about the modern, highly-financialised economy.

Minsky’s work stressed something else: the economy is an extraordinarily complex adaptive system. Its inner workings evolve through time. And it is populated by fallible humans, trying to navigate an uncertain world.

This month’s chart shows the massive expansion of credit provision outside the regulated banking system, especially via the asset management industry. A prime example of reflexivity and complexity in the post-2008 era. Rather than reducing systemic risk, this trend has transformed and relocated it.

Minsky challenged conventional wisdom about financial cycles. In reality, long periods of apparent stability are punctuated by brief but painful market mishaps. They appear to arrive out of the blue, but they are the inevitable consequence of fragilities, accumulating out of sight and, for many investors, out of mind.

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Financial markets are both a window through which we can observe economic developments and a fundamental driving force behind them. Cause and effect at the same time. Investors call this dynamic ‘reflexivity’. Expectations of the future affect the present. But perceptions of the present shape beliefs about what is to come.

In standard portfolio theory, lower volatility implies reduced investment risks. Minsky profoundly disagreed – and he was right. The actual danger of a significant portfolio drawdown rises as measured financial risks decline. This may seem counter-intuitive, but such a dynamic is hardwired into the financial system. Before the 2008 global financial crisis (GFC), this was due to how global banks managed their balance sheets. Now, it is a consequence of the dominant strategies in asset management. Volatility and price trends are the metrics used to scale risk asset exposures. Falling volatility and more stable price trends increase desired risk asset allocations. Which begets even lower volatility and larger flows into risk assets.

Today, the majority of investment capital is managed along these lines. Markets function more like voting machines (in which financial flows and liquidity dominate), than weighing machines (in which fundamentals drive asset prices).

But this is not the only potential driver of instability in today’s markets. Ruffer Co-CIO Henry Maxey explored a host of others in this year’s Ruffer Review. They include: the explosive growth of zero-day-to-expiry S&P 500 options (oDTE); the increasing footprint of multi-manager hedge funds (so-called ‘podshops’); the ‘run-risk’ in money markets due to the Fed’s overnight reverse repo (RRP) facility; the shift of derivative exposures, and related collateral management, to central clearing counterparties (CCPs); and the dominance of algorithmic market-making.

These dangers are lurking beneath the surface of buoyant markets. Individually, they are unlikely to cause severe financial stress; but together they could exaggerate any correction in markets. In today’s complex, tightly integrated and interdependent liquidity-fueled markets, the next sell-off will be more mechanical, mathematical and uncontrollable.

The consensus belief is that post-GFC regulation has left the economy and financial system in reasonable health. No obvious systemic threats remain. A run-of-the-mill bear market is all we should fear; and emerging signs of economic weakness will give us time to adjust portfolios.

But this is to forget Minsky’s pithy insight. A decade of historically cheap and plentiful central bank money has rewired the financial ecosystem, littering it with structures and behaviours that could supercharge any sell-off when it happens. Yet, markets are positioned with those dangers out of sight and out of mind.

#credit, #liquidity

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