Hedging against the spectre of stagnation

While some of the recent stock market sell-off has been driven purely by negative narratives, some hedge funds are making more permanent shifts.

Why has fear returned so virulently to equity markets in recent weeks? After rising steadily since February, both the ASX and the S&P 500 have dived by close to 10 per cent  from the September peak to last week’s trough.

One theory doing the rounds is that a vague sense of foreboding linked to “secular stagnation” – more on that in a minute – has broken into investors’ consciousness and made them suddenly risk-averse.

Secular stagnation describes a long-term phenomenon similar to economic depression: too much money hoarded in cash, insufficient economic demand, and gradually deflating prices that make the cost of debt ever higher.

Think of it as the ‘Japanification’ of Europe and the rest of us. A quarter-century of stagnant demand in Japan consistently eluded fixing by successive policymakers.

Now there are fears that Europe is headed the same way. The IMF sees a 40 per cent chance of a recession there over the next 12 months and a 30 per cent risk of deflation. Recent bond tenders in Germany and Denmark have returned negative rates.

While official interest rates remain close to zero, negative real rates might be the only medicine to spur investment and demand. And even then, the potential growth rates of developed economies may have downshifted permanently into a slower gear.

The stagnation theory first resurfaced last November in a speech by former US Treasury Secretary Larry Summers. It has only gained traction in recent weeks as European data disappointed, raising fears about a ‘lost’ decade or two of economic growth in the euro zone with implications for the struggling world economy.

Then this week in The New York Times, eminent economist and Yale professor Robert Shiller wondered whether the notion of secular stagnation could be partly to blame for the stock market’s recent bout of anxiety.

Perhaps this theory, which need not actually be true, was affecting investors’ behaviour and driving the sudden slump on Wall Street? Popular narratives such as secular stagnation, Shiller argued, could trigger a negative feedback loop as the change in investor psychology affects behaviour and ends up creating a real bear market.

Certainly, the implications for stock market investors would be severe if stagnation were the new economic outlook. So far it’s just the fear of that dire outlook that has surfaced in commentary.

But it’s not clear at all that it was the fear of a years-long depression that triggered the ructions in equity markets.

Rather, abrupt and powerful shifts in positions by hedge funds as they reversed major bets seem to have been at least partially responsible for the slide in equities and the sudden drop in the US 10-year Treasury yield to below 2 per cent.

Hedge funds had borrowed through the first half of the year to invest in plays that were predicated on a recovery in global growth. They bet that stronger demand including from China would fuel commodities prices, leading to an eventual pick-up in inflation and predictable response from central banks of higher interest rates.

Those gambles were highly leveraged. When commodities started to slide – including the price of oil -- hedge funds had to liquidate investments in stocks to raise cash and repay their borrowings. They also had to buy back bonds as it became clear that shorting bonds was a losing strategy, triggering the sudden dip in yields.

The sheer weight of money involved is impossible to quantify, but its effects on markets are crystal clear.  Speculative accounts dominate trading in oil futures.

Which brings us to a huge development. The largest US pension fund, Calpers, which represents California public employees, has decided it’s not worth the time and expense of monitoring its $4 billion investment in hedge funds and sold the lot.

Other public pension funds from Texas and Pennsylvania are considering similar moves. If more funds follow suit, they could not only reduce future investments in hedge funds; they could force a fresh round of liquidation. And that might be enough to trigger another rush for exits in equity markets.

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