Tuesday, April 30th, 2013

Too Much Moderation

Every time a financial journalist writes about the Great Moderation, there is an underlying sadness, a feeling that those halcyon days are gone, never to return. This was the Goldilocks era, from the middle of 2004 to late 2007, when equity markets – including Japan – rose every year, and managed to do so without upsetting the bond market.

The single most important characteristic of this period was the very low level of volatility generated by financial assets, not just equities. Between April 2004 and July 2007 the trailing 52-week volatility of US equities hardly ever broke above 11%. This compares with an average of 18% since 1995. Every other major and asset class and equity region saw volatility decline over the period. Investors, traders and policy makers loved it. We now know that it was facilitated by rising levels of leverage in the financial system and that it was nothing to do with a superior growth model or better fiscal policy.

So what should our reaction be, when we see that volatility for US equities is now approaching 12%? On our favourite measure, excess volatility relative to US Treasuries, asset classes as diverse as emerging market equities, corporate bonds and commodities are all trading well within the lowest quartile of the data for the last 18 years. The simplest explanation is that once again there is too much leverage, only this time it comes from the public, not the private, sector.

The best way of identifying a bubble is not valuation, but the way in which markets trade as we get there. Low volatility, particularly across a range of assets in relation to a risk free asset, is a sure sign that there is too much leverage at work in financial markets. It is attractive to investors, but it is also a danger signal. Central banks show no sign of wanting to restrict liquidity just yet, but when they do, volatility will have to rise and returns will have to fall. Current policies are unsustainable, but when they will end is another matter.

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