The era of dissonance

Sources of dissonance are challenging economic systems and financial markets with increased frequency and intensity. The result is a series of choices for financial markets in which they must weigh the probability of a dire outcome against a more benign scenario. The challenge for markets is how to cope with expectations when the two most likely competing scenarios are widely divergent.

Markets inherently have difficulties in pricing financial exposures when the only thing that is certain is that the status quo cannot last. As markets struggle with widely divergent scenarios, the volatility of markets becomes unstable as well as the relationships between exposures (i.e., the correlation structure). The risk management challenges from this “Era of Dissonance” are enormous, and they to go the heart of the asset allocation and risk-taking decision processes.

We are led to a sequence of recommendations involving active volatility management, including increased use of options, from the risk-taking implications of heightened instability of correlation structures. Financial practitioners should review and re-evaluate every assumption about how they structure their investing plans, as many old and embedded assumptions simply no longer hold.

To get at the heart of what is disturbing financial markets and to understand why it will not go away quickly, we need to focus on the sources of dissonance. Population dynamics, property rights trends and policy constraints form the three Ps of dissonance.

At one end of the population dynamics spectrum, we have the aging countries of Germany and Japan. They have more workers retiring than young people entering the labor force. The U.S. is not yet at this stage, but the aging process is well advanced. Countries with an older profile are much more likely to favor the policies of preservation of wealth and health. Long-term economic growth potential slows with a stagnant labor force, and politics shifts toward maintaining the wealth already created. This translates into a strong aversion to inflation, a preference for a stable currency, and a focus on how to pay for the health-care needs of an aging population.

Many emerging market countries, from Brazil to India, have almost half of their population under 30. There are more young people entering the labor force than there are retirees leaving. Job creation is a long-term, secular priority, not just a cyclical response to the last recession. Infrastructure building is critical. Countries in this situation are much more tolerant of higher inflation as a necessary by-product of building a more robust middle class. Exchange rate strength is not desired, as it is often perceived as hurting exports and hindering long-term job-creation plans. Creating extensive social safety nets and health-care programs do not have the urgency as in an older country.

China is an exception. China has the demographic profile of an aging country, because of decades of the one-child policy. Yet for now, China behaves more like a younger country, and this is due mostly to the huge rural-to-urban migration that is in progress. Effectively, China is creating one New York City every year, and this has given its political agenda a job-creating imperative, leading to an export-growth focus. The current 12th Plan for 2011-2015 suggests this focus is starting to shift. China's leaders are well aware that early in the 2020s, the average age of China will surpass that of the U.S. and the rural-to-urban migration will have slowed dramatically. Health-care challenges will take priority over job creation, and the urge to maintain the wealth that has been created will lead to a more open exchange rate policy and more domestic demand growth model, which also implies a much slower long-run average real GDP growth rate than the 10% pace of the last decade.

Our inclusion of property rights focuses on whether consumers and corporations can conduct their business on a level playing field (i.e., laws, rules, regulations, taxes) with an expectation that the rules and goalposts will shift in an orderly manner (i.e., political stability, consistency of court rulings and enforcement of contracts, etc.). It is extremely difficult, if not impossible, to measure quantitatively the comparative degree of property rights among countries, or the degree to which regulations enhance or degrade economic activity, or even the relative political risks that emanate from these sources. Our inability to measure something in a credible manner should not, however, become an excuse to ignore the challenges to the global economy from divergent trends in property rights and economic regulations, as well as their implications for market confidence in political governance systems.

In the last decade there has been a steady erosion of political stability and property rights in general in the mature industrial countries. The extremely high cash levels held by multinational corporations are reflective of the difficulties of planning for the future when everything from taxes to regulations is uncertain. By contrast, in the last decade, political stability, enforcement of contracts, and many other aspects of property rights have gained considerable traction in emerging market countries. That the absolute level of property rights is still higher in mature industrial countries is less relevant to capital markets than which way the pendulum is swinging.

The challenge of policy constraints focuses on the inability of the mature countries to bring flexible fiscal and monetary policy initiatives to bear on their post-financial crisis morass as they deal with over-indebtedness from Europe, to Japan, to the U.S. By contrast, the emerging market countries have strong long-term growth prospects, are not heavily indebted, and have sufficiently high interest rates allowing them the flexibility to cut rates if needed. Moreover the fiscal restraint of the mature countries promises a very slow growth decade for them.

Our key conclusion is that these sources of dissonance are extremely powerful and easy to underestimate because they are slow moving. We are setting up the conditions for a series of political clashes that will produce a long string of market destabilizing situations. That is, as the political choices become more extreme, markets will continually need to examine the probability of widely divergent outcomes. Does the U.S. pass the debt ceiling or default causing dire consequences? Does the euro fall apart or muddle through? Will China allow the RMB to float freely sooner or much later? Will Russia shut down wheat exports again? The possibility of widely divergent outcomes emanating from long-term sources of dissonance driving countries apart, strongly suggests that economic analysis must embrace political analysis to a greater degree than was seen in the post-WWII period when the major industrial countries were more in tune with each other.

In terms of market expectations, the existence of plausible scenarios that are far apart along with the presumption that the status quo is not sustainable builds additional volatility into the market and the level of volatility and the correlation structure are also subject to abrupt changes. In terms of probability theory, we are looking at a bimodel distribution of potential returns that looks nothing like a normal distribution. Quantitative models and risk systems with embedded assumptions of single-mode distributions, even fat-tailed ones, may produce less useful forecasts and lead the user to misplaced overconfidence. The instability of the correlation structure leads to rising correlations within an asset class at the exact time that risk is rising, making diversification a less effective antidote to market volatility. The instability of volatility leads to more active use of options, which directly price volatility, as a way to mitigate the increasing level of “vega” risk as it is called. All of this reinforces the “risk-on, risk-off” financial environment we have experienced since the financial panic of 2008.

In short, the last half of the 20th century will go down in history as a very exceptional period of global economic expansion. Following two horrendous World Wars with a Great Depression in between, the formerly protagonist industrial countries shared common objectives of peaceful nation-building through economic growth and trade. Moreover, despite large cultural differences, the various industrial nations had similar demographics with young and growing populations needing to be put to work. A coordinated global monetary system, known as Bretton Woods, was established to provide a framework for the maintenance of a stable, non-inflationary world financial system. The industrial countries took broadly similar approaches to the use of fiscal policy to encourage economic growth and cushion economic cycles, while accommodating well their different preferences for social programs.

Financial markets have entered an “Era of Dissonance” that will stand in sharp contrast to the relative harmony and economic expansion of the last half of the 20th century. The Era of Dissonance will not easily resolve itself into a more comfortable and predictable environment and may last as long as a decade or more. During this transition period to a new world order there will be a continual conflict between perceptions of reality, widely variant possible outcomes, and confused future expectations. Financial markets will remain challenged, with bouts of uncertainty concerning strikingly different potential outcomes. The dissonance will profoundly disturb the dynamic evolution of market returns, volatilities, correlations, and risk-taking preferences. Our understanding of financial risk management is likely to undergo critical changes, because simplified approaches and traditional “rules of thumb” will not work during this period.

Bluford Putnam is the chief economist and a managing director of CME Group.