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Bridgewater Warns Low Volatility Markets "Sow The Seeds Of Their Own Demise"

Excerpted from Bridgewater's recent market letter,

Market movements are driven by how conditions transpire in relation to what is discounted, leading to big moves when conditions are different than what was discounted and small moves when they are similar. Recently, the moves have been small. The following chart shows the absolute value of price changes across the markets that we trade over the past quarter and year, relative to history. As you can see, recent price moves across the markets that we trade have been as small as any in the past forty years.

Looked at another way, the rolling volatility of discounted growth and inflation has fallen to very low levels.

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Markets have a tendency to extrapolate such periods of low market volatility forward, and continue to assume that moves will be modest. That is what is now priced in. Options markets have shifted over the last few years from pricing in high volatility and fat tails to very low volatility and significantly decreased risk of tail events. Growth and inflation are discounted to remain moderate with little need to tighten monetary policy. Stable conditions, stable discounting of future conditions, low market volatility, and ample liquidity have led to a further movement of money from cash to assets and produced a further compression of risk premiums. This compression of risk premiums has raised asset prices, improving balance sheets, but in the process has further reduced the going-forward expected returns of assets. In essence, markets have pulled forward future returns into prices today, leaving less return for the future.

Stable environments normally sow the seeds of their own demise by drawing traders into more highly leveraged positions as they try to magnify smaller asset returns into the desired level of return on equity. Subsequent shifts then produce magnified reactions. 2006 was the most recent case in point. We see manifestations of this process in the tightening dispersion of the pricing of assets with more widely varying degrees of risk. We see it beginning to happen in the degree of frothiness of the corporate bond market. But we don’t see much excessive leveraging yet. There has been enough money printed that the leverage has been unnecessary. The withdrawal of the flow of money will have to be met by a commensurate rise in credit creation and leverage, otherwise asset prices will fall, which would produce a negative wealth effect on growth. This balancing act gets tougher as spreads get tighter and leverage gets bigger.

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We continue to believe that economic conditions in the deleveraging developed world are too fragile to withstand much of a rise in interest rates, but the drop in yields over the past few months and the continued improvement in developed economies have moved current pricing closer to equilibrium.

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Nonetheless, we are still very much dealing with the consequences of being on the backside of the long-term debt cycle, with debt levels still high and borrowers remaining sensitive to increases in rates and debt service costs. At the beginning of this year, bond markets were discounting a rise in rates that we thought was at the high end of the possible range. Now bond markets are discounting what looks closer to the mid-range of our expectations.

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In contrast, the continued normalization of the US economy, and in particular labor markets, is likely to put downward pressure on record-high US corporate profit margins, and the Fed is pulling back on stimulation. US valuations are unattractive as the movement of money from cash has continued to push prices up faster than sales, margins, and earnings; the long-term expected return of US equities is in the low single digits and roughly equal to the yield on long-term bonds (but with more than twice the expected risk).