BIS Quarterly Review, March 2018 - media briefing
11 March 2018
Volatility is back. Not across the range of asset classes: it has largely been confined to equities, with just a few ripples in sovereign bonds and exchange rates. And we do not know how long it will stay. But it is back, and some volatility is healthy. There are few things more insidious in markets than the illusion of permanent calm. As experience indicates, that illusion can set the stage for some of the largest and most damaging losses.
The period under review started to unfold along the same lines as the previous one, which itself traced a pattern that had been in place for some time. We saw an entrenched risk-on phase, with equity prices flirting with new headline highs, volatility at or close to multi-decade lows across asset classes, credit spreads unusually compressed, and strong portfolio flows to emerging market economies (EMEs). In addition, a depreciating US dollar eased conditions further for the many private and public sector dollar borrowers worldwide, especially in EMEs. As a backdrop, there were signs that global growth was strengthening and broadening further even as inflationary pressures remained subdued - what market participants had dubbed the "Goldilocks" economy.
Then, like a bolt from the blue, after a very shallow slide, on 2 February the US stock market went into a tailspin amid a surge in volatility, more than erasing the sizeable gains accumulated since the beginning of the year. As is often the case in such episodes, the market recouped part of the losses in the following days. Subsequently, it did not change that much, hovering at levels close to those prevailing in December, until trade tensions led to further market jitters at the beginning of March, after the Quarterly Review went to print. Other stock markets have followed a similar pattern, although losses in Japan have been somewhat larger and longer-lasting.
What explains such a sudden and disorderly drop in the US stock market? Bond yields had been drifting up for some time before the plunge - a key development during the period under review that extended a slow trend in place since the trough in September last year. And in the previous week they had proved quite sensitive to a Treasury announcement of large issuance across the maturity spectrum, which appeared to take market participants by surprise. But this had hardly affected equities. The trigger for the drop appeared to be the release of a strong wage growth figure in the United States, taken as pointing to the risk of an unexpected increase in inflationary pressures. The yield on Treasuries rose, and equities started to dive.
Soon afterwards, on 5 February, internal market dynamics took over, in a way reminiscent of the 1987 stock market crash. Back then, the protagonists had been automated trading strategies called programme trading and portfolio insurance. On this occasion, as explained in more detail in the Overview, it was the turn of the likes of exchange-traded products (ETPs), Commodity Trading Advisors (CTAs) and, seemingly to a lesser extent, risk parity strategies. What these investment vehicles, players and trading algorithms have in common is that they either take positions in volatility directly or, like CTAs, were wrong-footed and forced to sell in order to cover losses. As on previous occasions, leverage, be it overt or embedded in the various instruments, amplified the moves. Unlike on those occasions, volatility products now enabled participants to trade volatility directly. Hence the outsize spike in the VIX: while it is well known that volatility increases as the market plunges, the increase this time was way out of proportion to the equity market drop.
Where does all this leave us? A number of observations are possible.
First, the market wobble has not fundamentally changed the overall economic and financial picture. Financial conditions remain unusually accommodative. Credit markets have hardly budged: credit spreads have continued to tighten to multi-decade lows; and there are indications that other credit terms, such as covenants and the like, have ignored the market spasm. What's more, in the background, the US dollar, after a persistent depreciation, has continued to stay weak - a tell-tale sign of easing financial conditions, especially for EMEs.
The dollar's depreciation has been surprising, given the combination of tighter monetary policy and fiscal expansion, for some reminiscent of the constellation of the early 1980s, when the dollar appreciated strongly. That said, as we document in the Overview, it is not unprecedented. The dollar actually depreciated in the 1990s and 2000s, when the Federal Reserve made progress with its tightening cycle; and in the 2000s this also went hand in hand with a fiscal expansion. Possible explanations for the current depreciation include the very gradual and telegraphed tightening pace, the strengthening global recovery outside the United States, concerns over the unsustainability of the fiscal position, and statements in January by high-ranking officials understood to be aimed at "talking down the currency". Still, the truth is that it is very hard to tell. As the American satirist and cultural critic H L Mencken once said: "Explanations exist; they have existed for all time; there is always a well-known solution to every human problem - neat, plausible, and wrong." This could equally well apply to the rationalisation after the fact of surprising currency moves.
Second, the market wobble may well not be the last. Financial markets and the global economy are sailing in uncharted waters. And after an unusually long period of unusually low interest rates and accommodating monetary conditions, it would be unrealistic to expect no further market ructions. What we saw this quarter is simply the latest reminder of how such a period complicates exit, by inducing market participants' risk- and position-taking. In addition, it has highlighted just how much prevailing market trends depend on a benign inflation outlook. No doubt, the wobble has shaken off some positions - the equivalent of pressing a "reset" button. But the overall picture has not fundamentally changed.
Finally, all this underscores how delicate a task central banks are facing. They need to strike a balance between normalising policy, not least to increase their room for manoeuvre to deal with the next downturn, on the one hand, and avoiding unnecessarily derailing the expansion, on the other. And they need to do so in a world that, post-crisis, has witnessed a further increase in overall debt in relation to incomes and output. The path is a narrow one. And it requires the active support of other policies. The most recent protectionist rhetoric complicates matters further. Treading the path will call for a great deal of skill, judgment and, yes, also a measure of good fortune. But policymakers need not fear volatility as such. Along the normalisation path, some volatility can be their friend.
Cryptocurrencies and the active debate surrounding them are part of a broader debate on the nature of money in the digital age. Some of the breathless commentary gives the impression that cash in the form of traditional notes and coins is going out of fashion fast. In "Payments are a-changin' but cash still rules", Morten Bech, Umar Faruqui, Frederik Ougaard and Cristina Picillo show that physical cash is alive and well, and still going strong in most jurisdictions. Despite all the technological improvements in payments in recent years, the use of good old-fashioned cash is still rising in most (though not all) advanced and emerging market economies. Cash in circulation has risen from 7% to 9% of GDP, although it has fallen in Sweden and a few other places. The resilience of cash as a social institution reminds us of the importance of understanding the economic functions of money, beyond just the innovations in technology. On the other hand, card payments (credit or debit) are rising as well, from 13% of GDP in 2000 to 25% in 2016. People hold more cards and are using them for more and smaller transactions.
If the resilience of cash is an example of the enduring nature of something familiar, measurement of trade and current account balances is an example of something that has struggled to keep up with recent trends, especially the increasing heft of global firms. In "Tracking the international footprint of global firms", Stefan Avdjiev, Mary Everett, Philip Lane and Hyun Song Shin show how the activities of global firms affect and sometimes distort traditional measures of the trade balance, current account and GDP. National accounts are organised around the notion of residence, but "residence" is a legal concept that does not always coincide with the physical location of the firm's production activity and where its workers are employed. A firm that offshores production and sells to consumers globally is often treated as exporting the goods from the home country, especially when home country intellectual property inputs are used. Relocating legal domicile can set in motion a cascade of changes in the balance of payments of countries involved in a supply chain. The current account and GDP for small open economies are sensitive to relocations of global firms. Ireland saw its GDP grow by 26% in 2015, even though underlying domestic economic activity held steady.
The other special features cover more familiar BIS themes, addressing financial topics. In his remarks, Claudio has focused on recent financial market events. Fast-paced movements in financial markets hit the headlines, but slow movements in the background can matter more for the economy. Their importance becomes apparent only after some time.
In "Early warning indicators of banking crises: expanding the family" by Iñaki Aldasoro, Claudio Borio and Mathias Drehmann, the authors compare the performance of various indicators of future banking distress. They find that measures of household debt and international credit can provide useful signals, in addition to the more familiar ones based on aggregate credit. The authors also confirm that combining the indicators with movements in property prices improves their performance. Applied to the current scene, a range of indicators points to the build-up of risks in a number of countries. At the same time, the authors explain that interpreting correctly the information content of the indicators requires considerable care, not least given the improvements in banking regulation that have taken place in recent years. And high readings should instead serve as a useful starting point for a closer look at the vulnerabilities.
In "Common lenders in emerging Asia", Cathérine Koch and Eli Remolona examine the long sweep of developments in global banking from the perspective of countries in emerging Asia. The authors view events through the lens of the BIS banking statistics, going back to their inception in the 1980s. The early global leadership by US banks gave way to Japanese banks in the 1980s, which in turn gave way to European banks in the 1990s and 2000s. These ebbs and flows have been punctuated by crises and recoveries - notably the Asian financial crisis of 1997-98, the Great Financial Crisis (GFC) of 2007-09 and the European sovereign debt crisis of 2010-11, with the banks becoming a conduit for the spread of financial distress across countries. The wheel has turned full circle, and today Japanese banks are again the largest lender to the region, with 26% of claims. But Chinese banks are taking on an increasing role.
We can also look at credit flows in terms of what kind of institution provides the credit. Lending by Asian property developers is examined in "Mortgages, developers and property prices", by Michael Chui, Anamaria Illes and Christian Upper. The authors trace the activity of these developers, especially their increased borrowing. They point to how high leverage combined with tighter financing conditions could adversely affect property prices, while the low profitability of many property developers is another cause for concern. Some developers are also subject to currency mismatches. The growing role of property developers also has implications for the effectiveness of macroprudential measures. In contrast to banks, it is often difficult for authorities to set risk limits on lending, for example through ceilings on borrowers' loan-to-value ratios.
The increased heft of passive investors in financial markets is examined in "The implications of passive investing for securities markets" by Vladyslav Sushko and Grant Turner. Passive investing (investing in assets tracking the return of a benchmark) has grown rapidly. Passive funds now constitute 20% of investment fund assets and 43% of US equity fund assets. Exchange-traded funds (ETFs) are 40% of passive fund assets. These do not count funds that track an index implicitly. One driver of this growth has been the poor performance of actively managed funds. Passive investing could affect market functioning by increasing the correlation of returns and reducing fundamental research. Some argue that passive funds could exacerbate price movements by automatically buying or selling in response to investor inflows and outflows but, looking at past stress episodes, the authors find that passive mutual fund flows were relatively more stable than active ones, with ETF flows the most volatile.
In "The ABCs of bank PBRs", Bilyana Bogdanova, Ingo Fender and Előd Takáts analyse the determinants of banks' share prices relative to their traditional balance sheet quantities. Price-to-book ratios (PBRs) have been low for many banks in the past few years, despite higher revenues and intermediation margins. The authors develop a valuation model that incorporates traditional measures (asset quality, expected profits, the cost of equity), the potential contribution of intangible assets (such as the strength of borrower and depositor relationships) and other factors, such as size and leverage. Interestingly, these same variables determine PBRs both before and after the GFC - suggesting no major breaks despite the changes in post-crisis regulation. Nor have the key drivers changed much for global systemically important banks relative to other banks. A notable exception is capital: before the crisis more capital had a weak (and insignificant) negative impact on market values, while since the crisis it has had a large impact. It would appear that the market has started to reward better capitalised banks. An implication is that banks suffering from low valuations would do well to "do their homework" by reducing non-performing loans and reducing non-interest expenses.