US stocks tumbled to their lowest levels since November as fears of rising interest rates and inflation intensified. Seth Wenig/AP
US stocks tumbled to their lowest levels since November as fears of rising interest rates and inflation intensified. Seth Wenig/AP

Roller coaster stocks ride throws up some old memories



The global stocks roller coaster of recent days reminded me of three lessons I learned many years ago as an investor in emerging markets.

If well understood and applied, these precepts can turn unsettling volatility surges into longer-term opportunities. Long periods of market calm create the technical conditions for violent air pockets. Until last week, the most distinctive feature of many market segments was historically low volatility, both implied and realised.

Although several economic and corporate reasons were liberally cited for this development (including the convergence of inflation rates worldwide, eternally-supportive central banks, as well as healthy balance sheets and synchronised growth), an important determinant was the conditioning of the investor base to believe that every dip had become a buying opportunity, a simple investment strategy that had proven very remunerative for the last few years.

The more investors believed, the greater the willingness to "buy the dip". Over time, the frequency, duration and severity of the dips diminished significantly. That reinforced the behaviour further.

The economist Hyman Minsky had a lot to say about the phenomenon of prolonged stability breeding complacency as a precursor to instability. This phenomenon is reinforced by the insights of behavioral finance and can lead markets to embrace paradigms that ultimately prove unsustainable and harmful (such as the idea well more than a decade ago that policy making had totally overcome the business cycle, and the notion that volatility had been flushed or hedged out of the financial system). Crowded trades can be a lot more unstable than most investors expect.

This was the case this week with what are known as short-volatility trades, which come in many forms.

Some were explicit, such as buying products that return the inverse of a volatility index like the VIX. Others were constructed via combinations of puts and calls in derivative markets. Others still were implicit in some of the extreme positioning among institutional investors, such as taking large off-benchmark exposure in high yield and certain segments of emerging markets. And all of this reflected a willingness of investors to give up an unusual amount of liquidity, and to do so while being compensated little relative to history.

Initially, these trades became more and more stable, and handsomely rewarding, as more investors and traders embraced them. This made the opposite positioning - being long volatility - very costly to hold. With that, the late economist John Maynard Keynes' observation proved correct: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

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Under such conditions, it should come as no surprise that the unwinding of crowded trades can be extremely unsettling for markets as whole. Prices gap lower, liquidity erodes and those in distress scramble for indirect hedges, as imperfect as these may be. During market turmoil, investor differentiation gives way to indiscriminate action. As explained by the "market for lemons" theory put forward by George Akerlof, and by the work of Nobel Laureates Michael Spence and Joseph Stiglitz, it becomes very difficult to signal "quality" when the context is extremely noisy and volatility is unsettling. In violent market sell-offs, even solid names get treated as "lemons" initially. Then, provided investors can underwrite volatility, comes the best of all market bargains: picking up at cheap prices stocks and bonds issued by fundamentally solid entities, both private and public, with strong balance sheets, limited debt and favorable growth prospects.

All three of these lessons are relevant to the recent market movements, which have been technically-driven, and not by economic and corporate fundamentals. Indeed, these gyrations occurred in the context of improving, and not deteriorating fundamentals. And they have served to partially close the gap between elevated asset prices and what had been more sluggish fundamentals.

The market turmoil will likely lead to a healthier resetting of investor conditioning and, one hopes, greater respect for volatility and the importance of proper pricing of liquidity. After all, as the veteran investor Warren Buffett observed, "Only when the tide goes out do you discover who's been swimming naked."

Mohamed El Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as chief executive and co-CIO. He was chairman of the president's Global Development Council, chief executive and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."

Company profile

Name: Infinite8

Based: Dubai

Launch year: 2017

Number of employees: 90

Sector: Online gaming industry

Funding: $1.2m from a UAE angel investor

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Formula Middle East Calendar (Formula Regional and Formula 4)
Round 1: January 17-19, Yas Marina Circuit – Abu Dhabi
 
Round 2: January 22-23, Yas Marina Circuit – Abu Dhabi
 
Round 3: February 7-9, Dubai Autodrome – Dubai
 
Round 4: February 14-16, Yas Marina Circuit – Abu Dhabi
 
Round 5: February 25-27, Jeddah Corniche Circuit – Saudi Arabia

Mercer, the investment consulting arm of US services company Marsh & McLennan, expects its wealth division to at least double its assets under management (AUM) in the Middle East as wealth in the region continues to grow despite economic headwinds, a company official said.

Mercer Wealth, which globally has $160 billion in AUM, plans to boost its AUM in the region to $2-$3bn in the next 2-3 years from the present $1bn, said Yasir AbuShaban, a Dubai-based principal with Mercer Wealth.

Within the next two to three years, we are looking at reaching $2 to $3 billion as a conservative estimate and we do see an opportunity to do so,” said Mr AbuShaban.

Mercer does not directly make investments, but allocates clients’ money they have discretion to, to professional asset managers. They also provide advice to clients.

“We have buying power. We can negotiate on their (client’s) behalf with asset managers to provide them lower fees than they otherwise would have to get on their own,” he added.

Mercer Wealth’s clients include sovereign wealth funds, family offices, and insurance companies among others.

From its office in Dubai, Mercer also looks after Africa, India and Turkey, where they also see opportunity for growth.

Wealth creation in Middle East and Africa (MEA) grew 8.5 per cent to $8.1 trillion last year from $7.5tn in 2015, higher than last year’s global average of 6 per cent and the second-highest growth in a region after Asia-Pacific which grew 9.9 per cent, according to consultancy Boston Consulting Group (BCG). In the region, where wealth grew just 1.9 per cent in 2015 compared with 2014, a pickup in oil prices has helped in wealth generation.

BCG is forecasting MEA wealth will rise to $12tn by 2021, growing at an annual average of 8 per cent.

Drivers of wealth generation in the region will be split evenly between new wealth creation and growth of performance of existing assets, according to BCG.

Another general trend in the region is clients’ looking for a comprehensive approach to investing, according to Mr AbuShaban.

“Institutional investors or some of the families are seeing a slowdown in the available capital they have to invest and in that sense they are looking at optimizing the way they manage their portfolios and making sure they are not investing haphazardly and different parts of their investment are working together,” said Mr AbuShaban.

Some clients also have a higher appetite for risk, given the low interest-rate environment that does not provide enough yield for some institutional investors. These clients are keen to invest in illiquid assets, such as private equity and infrastructure.

“What we have seen is a desire for higher returns in what has been a low-return environment specifically in various fixed income or bonds,” he said.

“In this environment, we have seen a de facto increase in the risk that clients are taking in things like illiquid investments, private equity investments, infrastructure and private debt, those kind of investments were higher illiquidity results in incrementally higher returns.”

The Abu Dhabi Investment Authority, one of the largest sovereign wealth funds, said in its 2016 report that has gradually increased its exposure in direct private equity and private credit transactions, mainly in Asian markets and especially in China and India. The authority’s private equity department focused on structured equities owing to “their defensive characteristics.”