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.