A small bump in the road has a negligible impact when taken at slow speed. The story is different when one is speeding down the highway. The same applies in financial markets.
The US bond market is priced for perfection. With bond yields having come down quite a bit this year, to the great confusion and surprise of many analysts, the market is now expecting a very slow tightening cycle. Risky assets like corporate bonds, emerging market debt or equities are priced in reference to bond yields. When government bond yields are high in comparison to inflation, hardly anybody is interested in taking risk and risky assets will be relatively cheap. The opposite occurs when yields are very low. This means that by extension, most asset classes are more or less priced for perfection. Admittedly, the Fed will tighten as of next year but this has been anticipated to such an extent and should be so gradual that the transition should be very smooth. I call this view a ‘linear world’: a single piece of news (e.g. a rate hike or a surprising economic number) will have a certain economic or market impact irrespective of the starting position. Whether the economy is in recession or overheating or markets are cheap or expensive, it doesn’t matter in terms of the impact of news.
In reality the world does not evolve in a linear way. The impact of news depends on the environment implying that the world is full of non-linear reactions and developments. This means that small changes, even anticipated, can have a surprising impact after all.
Here’s a list of non-linearities:
1. Compound interest
This is probably the most obvious one: a small initial investment will in the long run become very big when you systematically reinvest the dividends or coupons.
2. Debt dynamics
This is the mirror image of the previous point: An initially small amount of debt will grow exponentially if the interest charges on the debt are paid for by issuing new debt.
3. Financial markets overshoot
Changes in expected dividends will have a disproportionate impact on equity prices because of swings in the investor appetite for risk.
4. Market liquidity effects
Disruptions in market liquidity also cause overshooting, something which happens in particular in corporate or emerging bond markets or in less liquid stocks like small caps. This typically occurs when volatility is rising, which creates an imbalance between demand and supply with nervous investors all trying to get through the (inappropriately small) exit together.
5. Capital expenditures of companies
Economists call this the accelerator effect. As the cyclical environment improves, companies at some point feel the time is ripe to increase productive capacity, rather than simply replace machines which have been fully amortised. As a consequence, the growth in capital expenditures gets a big boost and the percentage increase is far bigger than GDP. Because of this phenomenon, GDP growth surprises to the upside. In the current US situation, this is a genuine risk.
6. Access to credit
This concerns the willingness of banks to extend credit. When the business cycle picks up it will take a while until banks’ lending conditions ease significantly.
7. Collateral value for credit
Economists call this the financial accelerator. When the economy improves, the value of land, buildings etc eligible for use as collateral when applying for a loan rises. Borrowing capacity rises disproportionately compared to the increase of cash-flows.
8. Demand for credit
Credit demand will evolve in a non-linear way because of the previous argument but also because it takes a while to become sufficiently confident to take on more debt.
9. Discount rate effects
A minor change in the rate used to calculate the net present value of future income streams like coupons or dividends can have a big impact on today’s value of a bond or a stock.
10. Wealth effects
Big changes in the value of financial (e.g. equities) or real (e. g. property) assets can boost spending because people feel richer.
11. Willingness to take risk (risk appetite)
This is especially relevant when markets are falling: capital preservation becomes an overriding concern leading to an accelerated offloading of risky assets and further declines in stock prices.
12. Volatility spikes
Volatility will rise strongly when risk or uncertainty increase: investors sell risky assets or buy protection via options.
13. Portfolio insurance
This is closely related to the two previous points. The selling of risky assets now occurs because capital preservation (or at least limiting the downside risk) is an explicit objective of the portfolio manager and because the rise in volatility increases the likelihood that this threshold will be breached.
14. Operational gearing
Beyond the break-even point, when all fixed costs have been covered, profits will rise disproportionately because of operational gearing.
15. Capital flows as a function of fundamentals
At a certain point, the interest rate differential between two countries will become sufficiently attractive, i.e. offering enough a reward for the extra risk, and the carry trade will kick in, with money piling in into the higher yielding currency. It’s called hot money for a good reason.
16. Currency overshooting
This is a consequence of the previous point. Capital inflows (outflows) may be such that the currency becomes overvalued (undervalued).
17. Margin calls causing firesales
This is similar to point 7 (collateral value for credit). Levered equity positions will be closed when the value of the collateral used to create the leverage declines.
18. Animal spirits
Human psychology can cause wild swings in economic activity: a given disposable income and capacity to borrow money can lead to totally different spending behaviour depending on whether morale is high or low. When the business cycle picks up, at some point confidence will reach a stage that it causes non-linear reactions: animal spirits are kicking in. The next stage would be euphoria (followed by a crisis).
This long overview, which does not claim to be exhaustive, shows the complexity of economic dynamics. It makes forecasting a hazardous task. In such a non-linear world, it is small comfort to observe that markets are priced for perfection because the slightest ‘imperfection’ can have a surprisingly big impact. Think about fastening your seatbelts when we get into 2015.