What Separates a Bout of Risk Aversion from a Bear Market Crash?
- Risk aversion can be intense, but that alone doesn't reflect upon a systemic bear market or financial crisis
- Most of the focus on deeper financial tsunamis is usually paid to a spark or catalyst, but that has its limitations
- Systemic flight is a function of catalyst, complacency and over-exposure that threatens liquidity and thus market stability
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It's Important to Distinguish Mere Risk Aversion from Full-Tilt Bear Market
Though a charge of risk aversion may look like the beginning of a systemic unwinding of risk exposure, there is a dramatic difference between the short-lived chart of the former and the deep intent of the latter. There are quite a few bouts of notable risk aversion over the past decade, but it was clearly not influential enough to seed a seismic shift in speculative intent. The February tumble registered in US indices (like the S&P 500 and Dow) and spread throughout the risk-leaning market was sufficiently broad and clearly intense. However, it didn't come up as a trend...at least not for the US stock market. Why wouldn't this intense charge not readily translate into a full-scale unwind of speculative exposure? For the same reason similarly intense retreats have fallen short of the deep charge stretching back to the Great Financial Crisis (GFC). With the painful and broad tumble in speculative markets in August 2015 and January 2016, the motivation was explicitly a fear of China's repricing method for the Yuan and concerns of what that effort would provoke from global counterparts. The retaliation wouldn't come, so neither would genuine risk aversion. The August 2011 plunge from the same benchmarks is another notable example of unmistakable risk aversion without the scope necessary to change the global settings. US government financing was a critical contribution to that retreat, yet the S&P sovereign downgrade and the reasonable downshift in US indices didn't jump start a global risk aversion. Will we ever overcome this deep-seated complacency and the appetite for risk exposure? Yes, it is just a matter of timing.
A Fixation on the Catalyst
When it comes to tracking a total collapse in capital markets, there is an inordinate amount of weight afforded to the catalyst. However, it is rarely the case where the fundamental spark that gets the markets moving can keep up the pressure such that the markets naturally cross the Rubicon from complacency to outright fear. Trade wars for example pose a direct threat to both the countries that are in the direct line of sight of the onerous taxes as well as those that impose the burden - blowback is both intentional and happenstance. The trouble of spinning up a systemic trend from even the most wide-reaching headline relates to a inverse relationship between the scale of the event risk and the persistence of its influence. In other words, when the fundamental charge is severe, it usually offers up a limited period of influence. This is what we consider a 'flash in the pan' market response. The alternative is a slow but thorough burn in a concern that enters the speculative subconscious slowly. Whether the focus is emerging markets, tech shares, subprime housing derivatives or assets dependent on extreme monetary policy accommodation, the circumstances are all the same. The fundamental ignition needs to ignite dry tinder. That usually comes in the form of broad speculative leverage, complacency and ultimately liquidity.
Cumulative Circumstances that Culminate in Liquidity Gaps and Panic
If, back in 2007/2008, we had seen worry over the value of subprime housing asset backed securities (ABS) restricted to that singular asset class alone, our last decade would have played out very differently. Certain matters can cut deeper channels across the financial markets, but that doesn't necessarily translate into runs that can readily override subsequent top headlines or keep the speculative rank motivated well after the news has been absorbed by the speculative rank. To connect sheer volatility to genuine trend, we typically need to see the further influence of speculative unpreparedness and outright positioning that stands in contrast to the new reality that circumstances shape. Yet, the most critical element to ensure the escape of practical deniability is the outright threat to liquidity. When a sharp selloff finds breadth across the financial system and overwhelms the structure of an important financial market, the gaps in continuous pricing can stoke panic and urge holdout interests to throw he towel in. How close are we to such a market environment? We discuss the bridge from constrained risk aversion to systemic risk trend in today's Quick Take Video.