Market Maniac

Prudence Uber Alles
Jul 24, 2017

While Mr. Trump continues firefighting at the front office of his presidency, the back office is quietly at work focused on unwinding regulations that have kept businesses – in particular, non-renewables and the financial sector – contained to a reasonably straight and narrow path.


This is ironic and, at least in the case of the financial sector, it recalls the Italian philosopher, George Santayana, who pointed out that “those who cannot remember the past are condemned to repeat it.” It was the tightening of regulations after the 2008 crash that finally returned the big American banks to health and, indeed, strong profitability. Many of them have been able to once again institute “tasty” bonus policies for the first time since 2010. But Trump, who is deaf dumb and blind to history, has pledged to ease these regulatory constraints. And, of course, banks continue to lobby for more freedoms.


 


Trading income has been down at all the big players, a direct result of the sound constraints put on the industry. This has led to substantially lower volatility in markets over the past two years. Indeed, the VIX is at levels last seen just before the crash of 2008 and the volatility of gold is the lowest it has been since 2005. Many market analysts – self included – have been fretting about this extremely low volatility, wondering whether or when things will turn and come crashing down. The chart shows that gold volatility has reacted dramatically ever time it reaches around this level; further average time between two troughs in gold volatility has been about 20 months – the current cycle has been running for 24 months so the turnaround, assuming it is coming, is overdue.


Interestingly, none of us supposedly market savvy analysts have questioned whether this lower volatility, while bad for banks and financial media, has been good for the real economy. It is perhaps significant that following this period of low volatility, global growth has recovered nicely from the near-morbid state that prevailed till 2016. And while it is still nowhere near rock ‘n roll, most companies we speak with who are engaged with the global market are seeing steady, heading to strong, growth in exports, despite the rupee’s incongruous strength.


Indeed, central banks in the developed economies are also in various stages of tightening monetary policy, but are being somewhat circumspect out of deference to a possible fragility in equity markets – memories of the taper tantrum in 2013 are still quite loud. It is likely that they will continue to calibrate their action with more than one eye on growth, since the other variable – inflation – is still playing dead. This suggests that interest rate swaps may be a little expensive right now.


The Trump-driven shift of focus at the Fed and other US regulators could unleash the dogs of war in the financial markets, particularly if the Dodd-Frank separation of trading from lending is emasculated. The volatility chart would then complete itself. Gold could rise, threatening $ 1,350 an ounce and the dollar, which has already been on a weakening track, could fall further, and, perhaps, sharply. The newly confident EU will, of course, continue its prudent policies, which would naturally support the Euro against the undisciplined dollar. In the early stages, this could bolster Trump’s efforts to address the US trade deficit and US equity markets could well surge higher in another wave of irrational exuberance. Global markets would rise in sympathy and the rupee would remain under strengthening pressure.


This last wave will, of course be unstable – equity valuations are already stretched – and everything could come tumbling down in another vicious crash, triggered perhaps by some horrific denouement of Trump’s madness. Alternately, the market itself may overreach, as it always does, and come crashing down, bringing Trump along with it


When judgement day comes, the rupee will, of course, take a huge hit. Short dollars should find a way to keep enjoying the ride, but steadily widen their exit doors; long dollars need to keep on keeping on selling forward steadily, ideally following a structured process that captures as many birds in both hands while keeping a watchful eye on the bush.


How long this scenario will take to play out – or, indeed, whether it will – is anybody’s guess. The final casualty, as always, will be the real economy. Global growth, which is just getting going, could suffer another severe tumble in 2018, which could certainly last well into 2019. Indian policymakers need to pay heed to this possibility.


For businesses, don’t stretch yourself too far, however tempting it seems. Prudence uber alles!




Archives

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