Excessive Risk Taking in a Low Volatility Environment

While like many others, I'm not a huge fan of the International Monetary Fund (IMF), in preparation for the September 20th, 2014 meeting of the G-20 Finance Ministers and Central Bank Governors, the IMF released an interesting Note on Global Prospects and Policy Challenges that has some commentary that is worth repeating. 

The staff of the IMF begin by stating that the global recovery has been unbalanced with high private and public debt levels negatively impacting the economies of the world's advanced nations.  They go on to describe the world's current financial condition as quoted here:

"Valuations in virtually all major asset classes are stretched relative to past norms.  Long-term bond yields have declined further especially in the euro area but also in the United States and in most emerging economies.  Equity valuations have continued to edge higher, as investor sentiment has remained positive despite mixed evidence on the strength of the recovery and geopolitical tensions.

However, implied volatilities across asset classes have continued to decline, reaching levels prevailing before the Fed tapering talk. This raises concerns of a buildup of excessive leverage and under-pricing of credit risk which could be abruptly corrected in the run-up to U.S. rate hikes or because of higher global risk aversion." (my bold)

The authors go on to note that the recovery, while it is expected to gain strength over the remainder of 2014 and 2015, is expected to be weaker than was projected in the spring of 2014.  This is partly based on concerns that Europe's sluggish recovery will stall and that Japan's economy will see zero growth over the next 15 months.  The authors refer to this as "secular stagnation", a period of low growth and weak demand.

The IMF notes that downside risks to the world's economy have grown including:

1.) increased risk-taking and financial market optimism that could eventually trigger abrupt corrections.

2.) geopolitical risks including Russia and the Ukraine and the Middle East including Iraq and Syria.

Risks to the economy also include normalization of monetary policies by the United States and the United Kingdom.  With the recent "strength" in the labor market and rising inflationary pressures, there is a possibility that monetary tightening will have to take place faster than previously anticipated.  Here is another quote:

"Against the backdrop of increased financial market optimism—reflected in the compression of risk spreads and volatility indicators—such surprises could trigger abrupt financial market corrections."

The compression of interest rate spreads can easily be seen on this graph from FRED which shows how the spread between ten year Treasuries and CCC rated junk bonds has dropped since 2009:

Here is a chart that shows the volatility of U.S. interest rates:

Note the increase in volatility between May 22, 2013 and August 18, 2013?  That's when this happened to long-term interest rates as the bond market got ahead of the Fed on when tapering was going to take place:

The IMF is concerned about two issues:

1.) that the current very low volatility levels are associated with one-sided market positioning.

2.) that long-term interest rates still look very low compared to historical levels.

Both of these issues suggest that there are risks of abrupt market corrections ahead.

While the IMF quite obviously does not have a crystal ball, it is interesting to see that it has great concerns about the ongoing sustainability of both the bond and stock market valuations and that investors are now living in a world of unrealistically high valuations and low volatility given the fragile nature of the "recovery".