One of the most striking features of the current financial landscape has been the decline in volatility. The start of this year saw the Vix index, which measures investor expectations of US stock market volatility, dip below 10, half the average of the past 20 years.
The bulls are not surprised. They argue that this is simply the logical consequence of the “Great Moderation” in macroeconomic volatility that has taken place over the past two decades.
This decline in macro volatility not only reflects structural changes in the global economy, such as better inventory controls and greater outsourcing, but also reflects improvements in the conduct of monetary policy.
It has also given rise to the idea that the business cycle has become increasingly irrelevant. Financial assets have been priced accordingly: just look at the lack of differentiation in the credit derivatives market for insuring against the cost of default between cyclical and non-cyclical companies in Europe today.
Strong, predictable corporate cash flows are now taken as given.
But are they being taken for granted?
The pursuit of robust corporate cash flows originated in the bursting of the technology bubble and the US corporate balance-sheet crisis of 2002. Companies had little choice but to run themselves “for cash”, rather than “for growth”. US households’ credit-financed consumption played a major role in the corporate recovery that followed. In the process the corporate sector’s balance-sheet woes have been transferred to the household sector.
Consequently, US corporate metrics have never looked better, with corporate margins at all-time highs, while household metrics have rarely looked worse. If there is a storm brewing, the place to look will be in the US household sector rather than the corporate sector.
That is why the bursting of the US housing bubble is such a watershed event. The regulatory response to the sub-prime housing crisis could make matters worse. The tightening of lending standards and a reduction in credit availability will make it increasingly difficult to clear the US housing inventory overhang. If the marginal home buyer is denied credit, then lower house prices may have to play a greater role in clearing the market.
Falling house prices, the closing of the mortgage equity withdrawal window and a tightening of lending standards have the potential to make a major mark on the US consumer. And that’s before unemployment starts to rise. If US households respond to this by borrowing less and saving more, consumption growth will disappoint. In which case, it is just a matter of time before corporates feel business-cycle risk bite back with a vengeance.
The growing vulnerability and unpredictability of the US consumer has the potential to make corporate cash flows more volatile once again. And when that happens, managements usually respond by making their supply chain – both at home and abroad – take the strain.
Thus the cash flows of small-cap and emerging-market equities – two of the most fashionable investment themes of the past five years – could suffer as investors reassess credit risk that has been priced for perfection.
But the fallout from the return of the business cycle won’t be limited to a re-pricing of traditional credit. It could also challenge some of the new financial structures and innovations that have taken place over the past five years.
There must be a worry that some of the financial structures put in place today, in a world of cheap credit and low equity-market volatility, will prove unable to cope with the return to a more “normal” macro environment.
In a period of such rapid financial change, one cannot help wondering whether the mandates of the world’s central banks have been set too narrowly. They may have met their growth and inflation objectives, but unwittingly ended up presiding over an environment that has allowed new capital structures to spawn and mutate.
The risk must be that a destabilisation of US household-balance sheets and a return to more volatile corporate cash flows could not only take the Vix index back to 20, but also put these new financial structures to the test.
David Bowers is joint managing director of Absolute Strategy Research
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