Market volatility since last August has pushed people to wonder whether this is like 2008, or 1998, or what kind of crisis is this? The last 2 weeks have been brutal. Is this the beginning of something big or similar to August of last year that led to the October recovery? Who ever can claim to have a very high level of confidence on the answer is most likely lying or crazy. We have so far not made any drastic changes in portfolios thanks to a very high level of cash, which does not mean we should not be taking drastic decisions in the short-term. We can review a few themes that we strongly believe have a lot to do with the current volatility.

The basic idea underlying our views is that there are too many structural changes and phenomena that have no historical precedent or theoretical framework that can be used to understand and reduce the uncertainty around them. Moreover, those phenomena are for the most part not underlying fundamentals of growth, but mostly part of the monetary or financial overlay on the real economy, or artificial construct or distortion that has some non-trivial effect on markets. The strongest connection of these phenomena with growth is most likely through financial markets volatility. Some of those phenomena are:

·      China is the second largest economy in the world, and most importantly, has been the fastest growing large economy, with tremendous impact globally (on commodity prices, interest rates, etc.). We have highlighted many times the natural convergence process, where growth comes naturally off historical highs. However, since last year policy mistakes exacerbated a serious capital flight phenomenon. China’s international reserves peaked in June 2015 at almost 4 trillion dollars, but ended 2015 at 3.3 trillion. The local stock markets started falling earlier in the year, and the government stabilization efforts meant serious increases in local liquidity, which in a strong currency environment exacerbates any possible capital flight. In August the authorities changed the FX regime, allowing the renminbi to depreciate for the first time since 1994, but the depreciation was only 3%. When there is capital flight, and the currency is not allowed to float, local monetary policy cannot add fuel to the fire being expansionary, but the opposite. The Chinese authorities seem to prioritize stock market stability, adding liquidity, but the currency weakness process dominates. These mistakes add uncertainty. But the real source of uncertainty is the difficulty in assessing how much the currency will eventually move, how fast, its effect on local balance sheets, and how low is real growth at the moment. We would not be surprised if growth is already significantly lower than most forecasts, and that in the real economy the change at the margin is not significant.

·      US monetary policy normalization has just started, and it is an unprecedented process. The size of the Fed’s balance sheet got to a totally unprecedented level, and there is very little in terms of theoretical constructs to analyze and understand the implications of the monetary policy expansion experiment since 2009. Seven years into it, there is no consensus of what has been its effect on the real economy or on asset prices, making it very difficult to judge what would the effect be of normalization. We tend to believe that this issue on isolation should not be of significance, as we tend to see most of the expansion as not having had a serious positive impact, but actually a negative impact by distorting the price of capital globally.

·      Oil is most likely the single most important commodity input to the world economy (energy source), and its market is undergoing a serious structural change. For decades its price was distorted by the OPEC cartel. Shale and the Saudi strategy to combat shale is generating very large swings and volatility in its price, which is a new source of uncertainty. What remains a puzzle to us is why lower energy costs are negative for the markets. But the oil market is a very important market for global growth, and it is undergoing a seismic transformation.

·      Drastically lower oil prices has a second order effect that is negative to markets, which is the funding of oil producing nations budget needs by selling assets in their large sovereign wealth funds.

·      The structure of financial markets and their dynamics have changed significantly in the last 7 years. Regulation has reduced liquidity by reducing the capacity of banks to participate in risk taking trading. At the same time, new instruments and investment strategies have grown to such an extent as having a significant impact on how markets react to sharp moves. The growth of ETFs (exchange traded funds) generates high levels of correlation within asset classes, as investors get out of an index ETF produces a generalized reduction of its underlying assets. At the same time, investors following automated or hard rule-based model-based strategies sometimes tend to exaggerate moves as they are large and do similar broad based trades in size. These are structural changes in the financial markets that were not present 10-15 years ago.

Some of these structural changes have started to happen a long time ago (like the new regulatory environment in finance that cripples liquidity), but others are more recent, and the accumulation is quite staggering. More importantly, these events accumulate while the global business cycle continues to be mediocre and shows no signs of improving. It could be argued that US equity valuations got to a level that required an improvement in the growth outlook to produce higher earnings, and that this was the key event that triggered the recent re-pricing. However, one could argue that there are always several phenomena at play at any point in time. We agree. We see these as an accumulation of phenomena that increase uncertainty, and we see the Chinese currency moves as the trigger, both in August and in December. Back in August we were somewhat lonely highlighting the Chinese policy mistakes around the steps taken to produce a devaluation. Nowadays that view is consensus. We did not think they could repeat this mistaken approach, but we were wrong.

Whichever of all these explanations or phenomena you favor, it is clear that they all point to an increase of risk-premia due to higher uncertainty. Moreover, it can be argued that some of these phenomena are unlike previous events and are hard to fit in conventional theoretical frameworks that would allow us to produce scenarios and probability distributions with a decent level of confidence. We believe that there is always a basic conceptual framework to adapt in order to understand reality. But this does not mean it is easy or a generalized practice. Markets today are struggling to process all these phenomena at once, while dealing with the structural challenges of lower liquidity and higher level of correlation in markets.

Does all this mean this volatility shall pass and markets would recovery? This is clearly one scenario with a very high probability. However, we recognize that sometimes bear markets get momentum, capital flows have real growth implications, and previous excesses end up producing crises. Looking around the world, there are a few spots that can evolve into a non-trivial crisis with broader implications if they were to continue to deteriorate. China is certainly a possible source of continued uncertainty as it continues to converge, and policy mistakes or a large sudden devaluation would have broader implications. Brazil is another such hot spot, connected to China through its trade balance and capital flows. The international reserve accumulation of the last decades, and low level of government dollar debt make a sovereign crisis unlikely. But excesses have materialized in other segments of the credit markets, and there is where we can continue to see deterioration.

In conclusion, the current volatility has a crisis feeling to it. But there is no underlying fundamental reason for it, except for an accumulation of important non-fundamental sources of uncertainty that are potentially producing a re-pricing of assets. A broader deeper crisis is possible, and we need to monitor those hot spots and think of other potential sources of those. But this is not yet close to being the base case scenario.