It is very hard to explain the paradox of low volatility on the trading markets, record levels of stock indices, and reduced levels of investor turmoil despite growing political risk.
Today, most of the stock markets around the world are at or near historic record levels, and investor concerns are at its lowest point since its inception in 1990. It is a miracle that people, who invert shares, say there has never seen better environment and risks have never been smaller. However, it is questionable how long can it continue.
The political risk remains high. In the spring of last year, after the elections in the Netherlands and France, it seemed that the upsurge of the populists could have peaked. The subsequent elections in Germany and the failed coalition talks weakened the position of Chancellor Angela Merkel and posed a risk of political vacuum at the heart of the strongest economy in Europe.
The forthcoming elections in Italy and the Brexit talks are other sources of tension and uncertainty. Looking beyond the borders of Europe there are plenty of political “hot spots”, and the risk of trade disputes and protectionism can still break the recovery of the global economy. The argument that the uncertainty is great has empirical support. An index of economic policy uncertainty peaked in January last year and remains alarmingly high. Another reason for concern is the high level of geopolitical risk, according to a recent US Federal Reserve.
It is not difficult to find the source of political uncertainty in the developed Western countries. The drastic deterioration in the economic outlook, job insecurity, real wage stagnation, unsustainable pension systems and, above all, increasing inequality have created a mixed feeling of discontent and a sense of injustice. They are largely the result of long-standing structural problems. The recent upswing cycle in Europe should improve the situation with some of these problems in the short term, but it will not solve them. And although the economy is growing and unemployment is dwindling, wages are stubbornly low.
The recent data published by the International Monetary Fund show that while unemployment has declined to below 6% in developed countries as a whole, the annual wage growth has barely exceeded 2%. We can expect a further increase, but, according to many, it has not changed much. The prospect of an end to the mitigating monetary policy of central banks, the so-called quantitative easing, is another source of uncertainty.
Normalizing monetary policy means putting a cross of 10 years of quantitative easing, something the markets may be too complacent or unprepared. Never before the balances of the central banks were so inflated, the interest rates – so low and the global debt – so big.
Moreover, the contrary to the common sense nature of the economic upturn with its lack of inflation is an indication that we have already entered an unexplored territory where the classic rules of macroeconomic policy do not apply. The mechanism of the quantitative easing is not fully understood and remains contradictory, so the effects of tightening monetary policy are still not known.
That’s why it’s important to understand that we’re dealing not only with risk but with uncertainty. The risk is an expression of the “known unknowns”. The uncertainty reflects the “Unknown Unknown”. It means ignorance of the underlying mechanism, the probabilities and, worse, the potential results. So how to explain the mismatch between the very great uncertainty and the frustration of the financial markets? Markets are very good at opening, trading, and risk insurance, but they are not good at understanding the unpredictable nature of politics.
The uncertainty can not be measured. For this reason, the markets often ignore it and adopt a wait-and-see approach. The small volatility of financial markets today is deceptive and underestimates hidden risks or, more precisely, uncertainty. Investors and politicians should enjoy the upswing while it is there, as it will not last long.
It is necessary for the markets to prepare for the return of instability. The next significant materialization of uncertainty is just a matter of time.
In a period of uncertainty, the diversification of the investment portfolio is even more vital than when there is a risk. Prudent investment advice and solutions are more important than ever before.