An article by Gillian Tett in the Financial Times, “Trading volumes retreat with investor trust,” contends that the notably low trading activity of late is a sign of deeper changes in financial markets:
The most pernicious issue hanging over the system right now is a loss of confidence – not merely in the idea that the future will be a brighter place, but also, most crucially, about whether anybody is able to predict that future at all.
Think back, for a moment, to the halcyon years before the summer of 2007. Back then, it seemed to be such a cosy and stable economic era that economists dubbed it “the Great Moderation” and most investors and businesses had absolutely no qualms about making 10-year plans. Indeed, that was expected in a world, where long-term planning – armed with complex computer forecasts – appeared to be not just rational, but a hallmark of modern society, something that separated us from earlier ages.
However, the financial crisis has shattered that sense of complacency. And while the immediate panic that erupted in the autumn of 2008 has now ebbed away, in its wake it has left a loss of trust – and innocence. These days, investors and businesses know that the world can sometimes be a profoundly unpredictable and uncontrollable place. No longer does it seem wise for corporate boards (or investors) to make 10-year plans, instead, time horizons have shrunk and many businesses and financial players have developed a mentality more akin to third-world peasants, who create strategies – but do so with bated breath, constantly braced for fresh storms.
And in practical terms, there are a myriad of uncertainties – or potential storms – out there now. The political trajectory in the US, for example, seems pretty volatile, given the rise of populist rhetoric. The government is intervening in the economy in unpredictable ways and financial reform could potentially change capital flows significantly. New jitters are afoot about a double-dip recession and deflation too.
And just to make matters worse, the memory of the May 6 “flash crash” haunts the markets. In the past three months, US regulators and bankers have scurried around trying to work out what caused equity prices to gyrate so wildly that day. But, thus far, they have not offered any convincing explanation.
While I agree with Tett’s bottom line, I’m not fully on the same page with her in her assessment. First, I think she overstates and to my mind, somewhat mischaracterizes the mood of early 2007 (which is odd, since her articles then were pitch perfect). Perhaps government statisticians felt comfortable with ten year time frames, but corporations? Short-termism was rampant, due to bad incentives. but also the sense that technological change moves so quickly that it is futile to plan very far out. And as Tett herself chronicled, and other Financial Times writers noted, market participants knew the frenzied financial activity could not last forever. I’m putting up a summer rerun (set to be next in the series, so the timing is apt) that illustrates that there were warning signs aplenty in late 2006 and early 2007 of pending, serious trouble. Chuck Prince of Citigroup’s famed “dancing as fast as we can” quote epitomizes the mood: partying on the edge of a volcano everyone knew was due to erupt soon, with investors mistakenly believing that they could exit cleanly and profitably at the last possible moment.
So the mood was not complacent, it was overstimulated, frenzied, nervous, and with good cause. It wasn’t hard to see how out of line conditions were with anything “normal”: the tremendous risk spread compression, the explosive growth in CDOs and CLOs, and the related markets that benefited, the housing market and M&A.
And the big shock to confidence was the crisis itself, the fact that so many formerly stodgy markets (like money market funds, interbank lending, even the rock solid German covered bond market) were infected by risk and duly had heart attacks. Investors were traumatized. The fact that the markets have recovered to a fair degree does not mean they are over the wrenching experience of watching a big chunk of their net worths vaporize. I know people who did stay in and went 100% into cash when the S&P got back over 1100. That was close enough to recovery of losses for them, they didn’t want to be at the mercy of equity market volatility again.
That isn’t to say that we don’t have greatly heightened uncertainty in the aftermath of the crisis. But I regard it as an overstatement to place as much weight as Tett does on uncertainty about government policy (this frankly is corporate carping; if you were to do a spreadsheet and do scenario planning on various environmental factors in play, I strongly suspect that the range of plausible regulatory changes will have far less impact on projected profits, say, than the impact of a dollar or euro meltdown, an eruption of war with Iran, the outbreak of a global pandemic that epidemiologists say is long overdue, the collateral damage of a not unlikely rise in protectionism, to name a few. The reason that businessmen harp on regulations, and the media unwittingly carries their bags, is it is one of the few uncertainties that they might be able to influence).
But Tett is right about the demoralizing impact of the lack of explanation of the flash crash (see this related Wall Street Journal story; the fact that journalists are still chipping away at this nearly three months later is not a good sign), the failure to rein in algos and high frequency trading. Investors, not just retail, but even a fair number of institutional investors feel the deck is stacked against them (I would argue ’twas ever so, but they never questioned the system when being long was an easy way to make money).
But we are a long way from the revulsion towards financial markets of the later 1970s and early 1980s. Some restraint on behalf of dealers could help restore faith in markets. But like the fable of the scorpion and the frog, modern trading firms seem unable to change their nature, even when their conduct is self destructive.