Everyone wants to know what the market will be doing months -- or even years -- ahead. Many analysts and operators would probably settle for knowing what the market will do tomorrow.
Yet, while there is no crystal ball in finance or economics, there are a few individuals who seem to be plugged into some higher plane of understanding than we mere mortals. One of these is Marko Kolanovic, JPMorgan’s global head of macro quantitative and derivatives research.
Since the Great Recession, Kolanovic has built a reputation for staggeringly accurate predictions on macro factors. Indeed, so strong has his reputation become that CNBC sometimes adds “Half-Man, Half-God” to his title chyron.
We usually prefer to maintain a healthy skepticism toward macro forecasters, but Kolanovic’s track record and evident understanding of markets, economics and trading are almost enough to make us converts.
Lately, Kolanovic has been sounding the warning bell in the market. He sees a number of factors that have made the market more fragile. Those weaknesses could be laid bare in the next recession. Let’s discuss.
A fragile marketplace could buckle in recession
Something not widely understood by the general public -- or, indeed, much of the investment community -- is the potential impact of electronic market-making and computer-based liquidity. Kolanovic foresees serious risks built into the new market infrastructure:
“There’s this fragility in the marketplace that came with the new structure of liquidity, with electronic market-making, computers, and growth in passive. Passive assets and quant assets will grow, and computers and AI will have a bigger role in Ă‚Âmarket-making.”
Computer systems have brought increased technological sophistication and speed to capital markets. These structures have been crucial to the development of online brokerage and trading, as well as provided essential infrastructure for the vast pool of passive money in the market. But they have also played a key role in the rise of high-frequency trading and contributed to a potential passive investing bubble:
“At some point that’s going to end up badly—most likely when the next recession hits. Some of the problems around computerized liquidity are going to be fully exposed, and it may really deal a blow to investors and markets overall. Not that we are forecasting it with a certain timeline, but more that investors should have it in the back of their minds.”
A serious shock could overwhelm these structures. Fragility is a serious problem for any complex system. The impact on capital markets could prove severe in the event of a downturn.
How bad could it get?
Kolanovic has offered some of his thoughts on how things might play out in the next crisis, when the systemic fragility he now observes is exposed to the public. Specifically, market turmoil and heightened volatility may start as liquidity issues exacerbate a crisis-driven sell-off:
“They are very rapid, sharp declines in asset values with sharp increases in market volatility ... If you have these liquidity-driven sharp sell-offs that come at the end of the cycle, or maybe even causes the end of the cycle, then I think you can have a much more significant asset price correction and even more significant increase in market volatility.”
A liquidity-driven sell-off could exacerbate and deepen a crisis or downturn. It might, Kolanovic opined, even prove the root cause of the next market panic. This could happen thanks to the over-mechanization of trading, which has become dominated by passive asset management and algorithmic trading:
“Basically, right now, you have large groups of investors who are purely mechanical. They sell on certain signals and not necessarily on fundamental developments, such as increases in the VIX, or a change in the bond-equity correlation, or simple price action. Meaning if the market goes down 2%, then they need to sell.”
Thus, even a minor downturn could produce a “negative feedback loop” that could expand a minor crisis into a full-blown panic. That is a frightening prospect.
Verdict
While the prospect of fragile capital market infrastructure buckling under the pressure of a downturn is rather scary, Kolanovic is not sounding the alarm in haste. He sees it as a horizon risk. But it is one investors ought to be far more aware of than they are. If capital markets seize up due to little-understood technological limitations, a mundane downturn could be turned into something much worse. The probability of such an occurrence is relatively small, but it is the sort of high-impact event that must always be considered and prepared for. Still, if such a crisis were to occur, it might well require unprecedented government intervention to break the cycle:
"If you have this type of severe crisis, how do you break the vicious cycle, the negative feedback loop? Maybe you stimulate the economy by cutting taxes further, perhaps even into negative territory. I think most likely is direct central bank intervention in asset prices, maybe bonds, maybe credit, and perhaps equities if that’s the eye of the storm."
What should investors be doing about all this? Kolanovic has one idea: shift into value. On that score, we certainly agree. Especially in these strange and volatile times.
Disclosure: No positions.
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