Markets are ignoring global instability – but a reckoning looms
Despite simmering political crises and looming economic risks, markets are riding a low-volatility sugar high – fuelled by central bank interventions – but the longer reality is ignored, the sharper the eventual correction, says Helen Thomas
With markets taking an early summer holiday, basking in the glow of record highs for the S&P500, it can seem as if political risks are simply pesky flies to be swatted off a delicious Pimm’s and lemonade. Who cares if the Labour Party is eating its own majority over the devilish detail of disability benefits or that it fell to the Vice-President of the US to break a tie in the Senate to pass the landmark tax cut bill? Why bother to notice that France’s Prime Minister only managed to survive a No Confidence vote thanks to the backing of Marine Le Pen’s right-wing National Rally party? Or that the President of the Federal Reserve is set to become a lame duck within a couple of months once his successor has been named? Or that the tariffs which set off recession fears are due to kick in next week after the three month pause?
None of it matters when the Vix index, the so-called ‘fear gauge’, is plumbing towards the lows of the year. If volatility is expected to remain subdued then investors feel that they can plough into risky assets with impunity. This sets off a virtuous cycle, where steady increases in stock markets cause people to sell volatility, which encourages more buying of stocks as the Vix falls, and so on and so on. After all, what’s the point in owning insurance if it keeps expiring worthless?
Except this isn’t quite how insurance is supposed to work. The longer that time passes without lightning striking or floods descending, the more likely that the once in a lifetime event is going to occur at some point in the future. Our psychology doesn’t always work like this but financial markets are supposed to be rational mathematical aggregation machines. If some potentially volatile events lie ahead, and it’s cheap to own insurance against such an event, the price of the insurance should rise, not fall. In this way, prices should reflect all probable known information. If you want to protect yourself against war in the Middle East, trade tariffs between China and the EU, or a fiscally incontinent government, plenty of derivatives exist with which to do so. If Elon Musk might be deported or lose government contracts, the price of Tesla and SpaceX can adjust instantly to reflect this risk.
Everyone is incentivised to ignore bad things
But price formation in markets has changed. Rather than once bitten, twice shy, it has become profitable to be once bitten, twice excited.
The reason for this lies in the huge amounts of policymaker intervention in financial markets over the last 17 years, accelerating during the Covid pandemic. Quantitative Easing, bailing out banks, even going as far as purchasing ETFs directly – central banks have gone above and beyond to ensure the economy wasn’t dragged into a deep depression. Did they go too far? They have certainly embedded a Pavlovian response within financial markets of buying the dip as all sharp sell-offs will ultimately be stopped in their tracks. This has created a lopsided probability distribution where the upside looks far more likely to happen than any downside. Once this feeds into risk management models, everyone is incentivised to ignore anything bad happening.
Except these models cannot ignore reality forever. Like Wile E Coyote running off the cliff edge, legs pumping in thin air, the ground eventually intervenes. And so the longer we go without pricing in the political risks, the greater the fall back to earth. Rather than make regular adjustments to the price of UK Gilts now that the government is patently politically unable to meet its own fiscal constraints, we will wait until the Budget hoves into view and reality hits. At that point there will be a sharp re-pricing as the government will be unable to cut spending or hike taxes enough to fill the fiscal holes. If they can’t pass a bill to save £5bn on welfare with a majority of 165, how will they ever be able to take any tough decisions? The welfare reforms were only rushed in the first place to try and deal with the fiscal gap created by the OBR update to the economic forecasts around the Spring Statement. Three months later, the government can’t even legislate to pass the policies it gave to the OBR. At some stage markets will stop waiting for the government to satisfy the OBR, given it is unable even to achieve that. Gilt yields will rise as government credibility falls.
We know the risk now but it doesn’t pay to prepare in advance. Instead markets drink the liquidity Kool-Aid, ignore that it’s laced with vodka, and choose only to deal with the hangover later.
Helen Thomas is CEO and founder of Blonde Money
