by Eric Knutzen, CIO, Multi-Asset Class, Neuberger Berman
Take care not to mistake calm markets for fair weather.
By the time you read this note, we will know whether or not Hurricane Irma made landfall in Florida. The state declared an emergency almost a week ago. Since then the storm has crashed through the Caribbean leaving devastation in its wake. The U.S., for its part, has been bracing for impact even as it deals with the flood damage of Hurricane Harvey.
Our thoughts are with the victims of these storms, and we wish the best for those who remain in Irma’s path.
Financial Storms Suppressed
If Irma has hit Florida as at least a Category 4 storm, it will have been the first since Hurricane Wilma 12 years ago. Coming just a week or so after Harvey, this would be the first time on record that two storms of this magnitude have struck in the U.S. in a single season. But despite appearances, when it comes to the weather, longer periods of calm do not lead to a higher likelihood of more terrible storms in the future.
Financial markets can be different. An extended period of lower volatility and higher asset values can lead to greater risk-taking and increased leverage in pursuit of returns, making the potential storm much bigger should investors try to retreat.
Moreover, while humans can do little to suppress tropical storms, we can and do act to suppress financial storms. The past decade of extraordinary central bank interventions is a possible potent example of a financial storm deferred, and politicians are masters at cobbling together quick fixes for long-term, structural challenges.
Kicking the Can
Ironically, it was Hurricane Harvey that provided President Donald Trump with the cover for a quick fix for the impending U.S. debt ceiling and budget reconciliation tempests. He struck a deal with the Democrats to postpone these difficult decisions until mid-December to free up disaster-relief funds in the moment. Republicans in Congress who wanted to use the deadline to press for fiscal and structural reforms were not happy.
Treasury bills maturing in October, whose yields had climbed to September 2008 levels, rallied hard, and those maturing in December sold off. Amid all of this, however, long-dated bonds barely moved. After all, U.S. and global economic fundamentals remain slow but steady—the “Goldilocks” scenario—and it is true that all of our monetary policy and political can-kicking can help to extend this expansionist stage of the business cycle.
But investors should not mistake the current market calm for genuine fair weather. It could be the eye of a storm.
Things can stay calm if we keep moving with the hurricane swirling around us, but there are many things we might stumble over: a tactical error over Korea, or a decision by the Federal Reserve as it attempts to normalize monetary policy while recycling many of its senior personnel, or from a U.S. president piling more and more onto the legislative agenda of a divided Congress, alienating his own party and failing to push the debt ceiling pinch point beyond the next session.
None of these exogenous risks have blown markets off course yet, and, as with weather systems, buying time can allow their pent-up energy to dissipate. In the financial system, however, time can equally allow a Category 3 storm to ramp up to a Category 5.