During the second half of an interview with MacroVoices host Erik Townsend, Fasanara Capital fund manager Francesco Filia explained how the trillions of dollars in post-crisis asset purchases by central banks have bred a dangerous trend-following mentality that ultimately undermines the stability of markets and leaves stocks and bonds vulnerable to a vicious reversal.
Passive, trend following funds – which account for the bulk of daily flows across financial markets – have only helped exacerbate the situation. But what’s worse is market strategists’ refusal to acknowledge how these flows, which create destabilizing feedback loops, tend to drive trading. Instead, sell-side “experts” employ flimsy fake narratives ex post to explain trading activity. These narratives are often accepted without question or criticism by financial reporters at CNBC, the Wall Street Journal, Bloomberg…the list goes on.
While it’s much easier for strategists and traders to latch on to the narrative of the day during interviews and conversations with clients, Filia posits that both professional and retail investors are ignoring these fundamental trends at their own peril.
There was a moment in the market a couple of years ago where, whenever we saw bad data, the market was rallying, because they were expecting more monetary printing and more interventionism from the side of central banks.
A little bit later, when rates were falling because of deflation, the narrative was chasing yields. So the narrative was not that there is deflation, therefore there will be a recession, therefore there will be a deflationary bust. The narrative was that there will be a deflationary boom. So the narrative was chase yields. So go into bonds even if the yields are low (whenever there is some yields left), go into equity to get some yield, and so make equities more expensive.
Then later on, pretty much about when Mr. Trump won the elections, you had a new narrative coming in, which was chasing growth and chasing reflation. And the whole market was repositioning for that, going long banks and short utilities, and so forth.
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At some point the reflation story was challenged, because it was all too clear that it was not really happening. You could see that the big pickup in soft data was closing the gap down to the downside on hard data. And you could see that the hard data were always very weak, and soft data went up and then came back down. So the reflation story was not there anymore.
But then there was another story that could convince investors that what was happening was making sense, which was to chase earnings. Earnings around the middle of this year, after the second quarter, they were the one bit of positive information out there. So the market was focusing a laser focus on that only, and that was becoming the driving narrative. But it was a fake narrative. Because, in reality, it was really about flows, in our opinion.”
Which brings us to the narrative strategists have ascribed to this year’s rally: The myth of synchronized global GDP growth.
But investors who believe this to be true are overlooking the fact that most of this “growth” has been fueled by debt and money printing. As Erik Townsend points out, “it shouldn’t come as a surprise that there’s global synchronized growth when there’s global synchronized money printing.”
The current narrative nowadays is synchronized global GDP growth. How many times have you heard that? And then, we see it all the time, and that is justifying the fact that the indices are reaching new heights. Except nobody is discussing about how this growth is achieved for much debt. And the debt on GDP that is on the shoulders of governments that is unheard in modern financial history.
So our point in this slide is that the fake market cycle is trying to prove that it is not really about narratives. The narratives are exposed and they’re just handy excuses. But the point of this – market is about flows: the passive flows from the public central banks, from the private investment community, from the EFTs, to all the new investment strategies. And our point here is to challenge our assumptions about the market and be prudent because, you know, the future is really wide open. Anything could happen now that flows are coming back and for the first time we see tapering and quantitative tightening.
The discussion soon turned to a concept that Filia famously helped pioneer: The notion that markets in recent years have succumbed to a positive feedback loop that has undermined their credibility and stability, as investors – spurred by overly generous and meddlesome central banks – have embraced high-beta, long-only positioning.
As markets become increasingly fragile thanks to this lopsided positioning, small changes in circumstances can have an outsize impact on markets.
Whenever there are positive feedback loops – and that is true in engineering, in cybernetics, in chemistry, in biology – whenever you have that you have the possibility of a self-fulfilling prophecy and a reinforcing process. You have reflexivity. You have a number of things that provoke a further diversion from fundamentals, or call it from general equilibrium, and system instability.
And this is the case right now, in my opinion. The system instability is further defined as a state in the markets in which a small disturbance is able to produce a very large adjustment.
So whenever – you said before what is the catalyst? And I said there could also not be a catalyst, that things could happen all of a sudden because of this very fragile state of affairs and because of the fact that it’s very unstable, this equilibrium.
And, to use an analogy, when you talk about an unstable equilibrium, you should think of a pendulum which is held in the vertical position. And the pendulum that is held in the vertical position stands still, it looks really stable. But a small disturbance is able to crash it down left or right.
When the equilibrium is stable instead of unstable, you should think of it as a painting which is attached to the nail – and it can move a little bit left and then goes back to the original position, a little bit right and then goes back to the original position. The market is like a pendulum held in vertical position, in our opinion.
So what happens? There are these massive public passive flows, these are central banks. In the last ten years, roughly, they printed $15 trillion. And they’ve spent that money to buy financial assets. Primarily government bonds, but also some risky assets like mortgages. And in some countries, as I said, Switzerland and Japan, also directly equities. Japan owns the majority of the ETF industry in Japan for $200 billion (equivalent). And the Swiss central bank owns $100 billion worth of stocks, primarily US stocks.
Private investors, of course, aren’t blind to activities of central banks.
They see the writing on the wall and adjust to account for the massive central-bank put that has buoyed markets since the crisis. However, this has created an environment where the entire market is effectively long – either by shorting volatility or by betting on the trend to continue. Meanwhile, fashionable trend-following investment strategies like risk parity have only helped exacerbate this weakness.
Now, we live through the peak QE. What are the two major factors that were originated by this $15 trillion printing and these huge monumental money flows? There are two. There is a factor trend and there is a factor volatility. The two consequences of those flows were trending markets – upward, obviously, because of all those flows. And financial repression of volatility, which means, really, volatility being killed to the ground and going into new all-time lows.
Those are two consequences of those monumental money flows. Those two factors have an impact. A reflective impact on the private community. Because the whole private community adjusts to those two factors.
So here we have a cursory look at all the players involved – some of the players involved – going from ETF and positive index files to all the fashionable investment strategies nowadays of risk parity, risk premia, algorithmic short volatility, machine learning, etc. And you can see that 90% of the investment community is affected by either one of those factors – volatility or trend – or both of them. 90% of the most fashionable investment community, and the most successful at present, is either going long trend – so long only – or it is shorting volatility or benefiting from low levels of volatility.
The popularity of passive ETFs has contributed immensely to this…
So, if I can spend a minute on this, a minute more, I will say that ETFs are the most – what you would expect – rates are going down, so it is very difficult for managers to make a performance and to justify fears. Therefore, there is from the investment community an obsession for fears. Therefore these ETFs are able, obviously, to be produced for very little cost, for total expense ratios of less than half a point and for management fees of 9 basis points or even smaller than that. Even we have seen some ETFs for 3 basis points of management fees. So they are a byproduct of the current environment of lower and lower interest rates which is produced by central banks.
What do they do, the ETFs? They obviously go long only. By definition. They don’t price any risk inside portfolios. ETFs, when you buy a certain subset of the market through an ETF, that ETF will not decide to be underweight for any reason. Not because there is a big election coming up, not because there is a potential nuclear strike in North Korea, not because there is a valuation problem – that investment will be mindless and will be long only and will be fully invested.
And this is number one: Now the ETFs alone represent close to 90% of the equity flows daily on the S&P these days. And this is an estimation coming from Vanguard, which is the number one shopper for ETFs. A different estimation from Bank of America sees 70% of the flows due to ETFs. But, you know, you are talking about a very big percentage.
…Short-vol ETFS in particular – as the Macro Tourist Kevin Muir pointed out in a post-game interview with Townsend – pose a major threat to market stability. Short-volatility positioning is so overwhelming, that a modest reversal in stocks and bonds (remember, it’s been more than a year since we’ve seen a 3% intraday drop in the S&P 500) could cause the VIX to spike. If the VIX were to double from its current levels – say it goes from nine to 18 during a particularly volatile trading day – these funds run the risk of being totally wiped out.
So, if I can spend a minute on this, a minute more, I will say that ETFs are the most – what you would expect – rates are going down, so it is very difficult for managers to make a performance and to justify fears. Therefore, there is from the investment community an obsession for fears.
Therefore these ETFs are able, obviously, to be produced for very little cost, for total expense ratios of less than half a point and for management fees of 9 basis points or even smaller than that. Even we have seen some ETFs for 3 basis points of management fees. So they are a byproduct of the current environment of lower and lower interest rates which is produced by central banks.
What do they do, the ETFs? They obviously go long only. By definition. They don’t price any risk inside portfolios. ETFs, when you buy a certain subset of the market through an ETF, that ETF will not decide to be underweight for any reason. Not because there is a big election coming up, not because there is a potential nuclear strike in North Korea, not because there is a valuation problem – that investment will be mindless and will be long only and will be fully invested.
And this is number one: Now the ETFs alone represent close to 90% of the equity flows daily on the S&P these days. And this is an estimation coming from Vanguard, which is the number one shopper for ETFs. A different estimation from Bank of America sees 70% of the flows due to ETFs. But, you know, you are talking about a very big percentage.
One of the most harmful byproducts of central banks’ nearly decade-long post-crisis monetary experiment has been to exacerbate income inequality by failing to produce inflation, except in financial assets. Instead of creating a wealth effect that would help boost consumer spending and, by extension, boost economic growth, the central banks have instead created an inequality effect that has numerous unintended consequences – the rise of populism in Europe and the US is perhaps the most striking example.
Self-congratulatory central bankers like Janet Yellen have never hesitated to defend how the Fed and its peers in Japan, Europe and the UK responded to the crisis. But the great policy experiment that began ten years ago is nearing its end. As Filia points out, as the Fed raises interest rates and starts paring its $4.5 trillion balance sheet and the ECB continues to taper, markets will experience a liquidity drawdown of nearly $1 trillion next year alone.
This drawdown will represent the first real challenge to financial markets in ten years.
How passive investors react to this paradigm shift will ultimately steer the broader market’s response.