After what were in retrospect very benign conditions for investors in 2017, volatility and risk have returned to markets. This in itself should neither surprise nor alarm us, as some element of volatility and risk is an inherent part of investing, and if anything markets have been too quiescent and complacent of late. Indeed the bigger question is perhaps not why markets are more volatile than last year, but why, given the length and strength of the current equity bull market and the political and economic backdrop, they are not more nervous still.
The list of things that markets and investors might worry about is on the surface large. In the political arena, relationships between Russia and the West have deteriorated to a level not seen since the Cold War, with accusations and counter-accusations flying and any semblance of trust and diplomatic correctness fast evaporating. The United States remains unpredictable with protectionist rhetoric rising, led by a White House which seems to disregard all the standard economic theories and received wisdom on trade, while no-one can say with confidence whether the “talks about talks” with North Korea will lead to lasting peace or a resumption of more acute hostilities.
Closer to home for most of our readers, Europe continues to delay and prevaricate over the completion of the banking union – a textbook case of failing to mend the roof while the sun is shining that the EU may come to regret in any future downturn or banking crisis – and Brussels appears to have no answer to the challenge posed by the illiberal regimes in Poland and Hungary. Meanwhile Britain seems no closer to solving the several conundrums posed by Brexit, of which the Irish border question is only the most challenging and least tractable of many.
On the economic front, the current positive state of the global economy belies some serious imbalances. President Trump’s extensive tax cuts will further fuel a US economy that is already growing at a rapid rate with full employment and rising inflation, and the spectre of growing twin deficits (budget deficit and current account deficit) is causing the US dollar to weaken significantly. In Europe, Germany seems either unwilling or unable (or possibly both) to boost domestic consumption and curb its excessive current account surplus, resulting in the country having an ever-growing structural TARGET2 surplus at the ECB which the Eurosystem was neither designed for nor has a remedy for.
And yet, markets seem to take this all pretty much in their stride. Volatility is a little higher, asset prices are a little lower – but in general the long bull market remains intact.
In fact it is not unusual for bull markets to ignore or dismiss bad news. It is well known that “Politics does not matter for markets, until it is the only thing that matters” – that is, markets will generally ignore developments in the political sphere for as long as they can, and then when politics cannot be ignored any longer, they react exclusively to the political story and nothing else. The same phenomenon can be observed with economic data too – a bull market will shrug off poor economic data for some time before suddenly taking collective fright and turning the screens red.
Behavioural economists see this as a reflection of a wider phenomenon known as confirmation bias. This is the tendency for people to pay much more regard to information that confirms what they already believe than to information that challenges it. We seek confirmation that we are right, we do not like to be forced to change our minds. And when the adverse evidence is finally too much for us to ignore, we can react very aggressively. This is the Tipping Point, when we are in effect tipped from one mindset to a different, indeed often completely opposite one.
There have been several clear examples of tipping points in the general news recently. Perhaps the most striking example is the West’s reaction to Russia over the Skripal poisoning and the use of chemical weapons in Syria. Russian officialdom appears taken aback by the West’s furious response to these two, in themselves, fairly minor events – for the Kremlin it is business as usual, they have always behaved like this and the West hardly reacted with such anger and hostility to the invasion of Ukraine, the shooting down of flight MH17, the numerous cyber-attacks on the West, even the blatant and state-sponsored Olympic doping. What, they ask themselves, is so different this time?
A larger and more interesting Tipping Point has been the change in public sentiment towards the world of international finance. There have always been aggressive operators in markets, people prepared to bend the rules, with questionable morals and sharp practices. And while people generally disapproved, up until about 2008 only a few of the most blatant or egregious offenders were caught and punished, and by and large the general response was “Yes we know it goes on, but what can we do?”
Until it wasn’t. The financial crisis was the Tipping Point, and Society’s response changed completely, from a general shrugging of the shoulders to revulsion and a determination to root out malpractice that finance has still not fully understood, still less emerged from. And again, financiers think that Society is being unfair, and in private ask themselves “What is so different this time?”
A more minor but again completely textbook example was – with apologies to those who do not follow cricket – the shaming of the Australian national cricket team when they were exposed as cheats in their recent series in South Africa. To anyone reading the news as it unfolded without knowing the background, the responses from the world media and the Australian cricket authorities would seem gross over-reactions.
But that is to ignore the degree to which the world of cricket had, in the face of mounting evidence to the contrary, stuck to the line that the Australian team was “hard but fair”, that their behaviour was “unsavoury perhaps but not illegal”. Then, when matters reached the Tipping Point when the evidence could no longer be ignored, all of the pent-up frustration at the team’s behaviour and style of play was released at once.
This then is the nature of confirmation biases and the Tipping Point – contradictory news is repeatedly ignored or explained away until a single event, perhaps in itself comparatively minor, becomes the straw that breaks the camel’s back, producing a reaction out of proportion to its intrinsic importance.
In the markets, confirmation bias means that investors who are positioned for markets to continue to do well will ignore adverse news until something, often in itself quite small, occurs to trigger a reappraisal. The weight of negative stories then cannot any longer be ignored and investors’ optimism is overwhelmed – at which point they can become suddenly and even unduly pessimistic and market sentiment swings completely round.
So where does this leave the current market? All investors know that bull markets cannot last for ever, and the current bull market has been, as we have already observed, both long and strong– indeed there have been few bull markets since the Second World War that have lasted longer, and on some measurements none that has been as strong. This makes those holding assets more nervous, as they have bigger gains to protect, and more likely to scan the news with a weather eye, looking for what might cause others to start the selling. So the likelihood of a breakdown, a tipping point, in the near to medium future is increasing.
But that is all we can say. At this juncture we cannot predict what the final trigger will be, or when it will come: perhaps it will be the irretrievable breakdown of Britain’s negotiations with the EU, perhaps a bank failure in the Eurozone. Quite possibly it will be something which is not even on people’s worry list at all at the moment. Nor can anyone say how severe the market reaction and reversal will be after we have passed the tipping point– as the market surely will at some stage.
But that is the nature of tipping points.
 The TARGET2 balances are the individual positions of each Eurosystem national central bank at the ECB. They arise from imbalances in payments between countries, and are unremunerated, unlimited and undated – that is, there is no maturity date to force a debtor country to make good its position and pay off its borrowings, and no interest payable if they do not. They were only ever expected to be modest clearing balances, but because of Germany’s persistent current account surpluses, now running at 8% of German GDP, the imbalances are becoming extreme, with Germany alone owed nearly €1 trillion. It is a moot point whether the money will ever be repaid; but meanwhile, the existence of the TARGET2 balances and the ease with which a deficit country can “borrow” from surplus countries frustrates any attempt to rebalance intra-EU trade and put it on a sounder and more sustainable footing.
 This is emphatically not to downplay either atrocity, especially not the Syrian regime’s use of chemical weapons on their own civilians. But it is hardly the first time either has occurred; indeed Syria has been regularly and fairly openly using chemical weapons for some years, while poisoning ex-spies is not exactly unknown behaviour for the Kremlin.