BY JOHN MAULDIN

This is something I’ve been pondering for some time. I think the next crisis will reveal how little liquidity there is in the credit markets, especially in the high-yield, lower-rated space.

Dodd–Frank has greatly limited the ability of banks to provide market-making opportunities and credit markets, a function that has been in their wheelhouse for well over a century.

However, when the prices of massive amounts of high-yield bonds that have been stuffed into mutual funds and ETFs begin to fall, and the ETFs want to sell the underlying assets to generate liquidity, there will be no buyers except at extreme prices.

My friend Steve Blumenthal says we are coming up on one of the greatest buying opportunities in high-yield credit that he has ever seen. And he has 25 years of experience as a high-yield trader.

There have been three times when you had to shut your eyes, hold your breath, and buy because the high-yield prices had fallen to such extreme levels. That is going to happen again.

But it is going to unleash a great deal of volatility in every other market. As the saying goes, when you need money in a crisis, you sell what you can, not what you want to. And if you can’t sell your high-yield, you end up selling other assets (like equities), which puts strain on them.

But that is not just my view. Dr. Marko Kolanovic, a J.P. Morgan global quantitative and derivative strategy analyst, has written a short essay called “What Will the Next Crisis Look Like?” and it’s this week’s Outside the Box (subscribe to this free weekly publication here). He sees additional sources of weakness coming from other areas, too.

Frankly, the lack of volatility is beginning to scare me a bit. Minsky constantly reminded us that stability begets instability. Stability is a pretty good word to describe the current markets.

But such stability always ends in a "Minsky moment." We don’t know when; we don’t know where it starts; but we know it’s coming.

What Will the Next Crisis Look Like?

By Marko Kolanovic, PhD, and Bram Kaplan
October 3, 2017

Next year marks the 10^th anniversary of the Great Financial Crisis (GFC) of 2008 and also the 50^thanniversary of the 1968 global protests against political elites. 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 ~$15T of financial assets, mostly government obligations. This accommodation is now expected to reverse, starting meaningfully in 2018. 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, and hence cannot be known accurately. 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 market developments since the last crisis:

• Decreased AUM of strategies that buy Value Assets: The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. The ~$2T 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.

• 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.

• 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 ~$1T 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 increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014 and August 2015.

• Miscalculation of portfolio risk: Over the past 2 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 are 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 downside risk are deemed perfectly safe by these models.

• Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true 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 crypto- coin offerings’ that in many cases have very questionable value.

We believe that the next financial crisis (GLC) will involve many of the features above, and addressing them on a portfolio level may mitigate the impact of next financial crises. What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t 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 (e.g., see here). 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 AI, 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 by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think 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, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US 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.

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