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How do you explain the swings in the equity market? One day it is Greece, the next day it is unemployment and the next day it's a natural disaster. What do you think is causing this volatility?
As we have written in the past, we continue to believe that a number of forces have led to an increase in the average level of price volatility in many asset classes. The first is the rise in uncertainty about the future actions of political leaders and the fundamental value of many financial assets. The second is the aggregation of many trading strategies into "risk on" and "risk off" trades, that result in simultaneous changes in supply/demand conditions across multiple asset classes. The third is growing concerns about global liquidity and funding conditions, due to worsening conditions in Eurozone sovereign debt markets, and their uncertain impact on bank balance sheets and funding. Changes in liquidity conditions can cause changes in lender collateral requirements, and precipitate waves of selling of liquid assets (e.g., large cap equities) in order to raise the required cash (for more on this, see "Haircuts" by the Bank of England's Andrew Haldane). The fourth is the increasing profusion of locations in which such transactions can be executed (e.g., the declining market share of traditional exchanges, and the rise of crossing networks and dark pools), which has only increased the price impact of forced selling. Finally, and perhaps most important, is the increasing volume of daily trading in many asset classes that is driven by evolutionary algorithms that track a wide variety of technical factors. In such a "Borg-driven market", not only are events like the May 6, 2010 "flash crash" more likely, but so too are high volume waves of buying and selling that collectively result in higher volatility levels. To us, the truly strange thing about the mainstream media's commentary about rising volatility has been its failure to fully explore and explain the implications of a market that is now largely algo-driven. Instead, they have continued to push an outmoded story line that somehow daily price movements are mostly explainable by the flow of news. We believe that this is no longer the case, and a range of other important factors are now at work that are underappreciated by most investors.
What do you view as the risk free asset today?
In general, we continue to believe that the best proxy for the risk free asset in the world today is short term government debt in an investor's functional currency (the currency in which the majority of his or her future liabilities are denominated). Granted, there are nuances to this definition -- for example, within the Eurozone, it is clear that German government securities are a better proxy for the risk free asset than those issued by Greece. Short term government securities generally have excellent liquidity, and little inflation risk, which are two primary characteristics of a risk free asset. Of course, the third characteristic of a risk free asset is the absence of default risk. Theoretically, any government that controls the issuance of the currency in which its debt is denominated should always have the capability to repay its debt. Today, among the functional currencies we cover in our model portfolios, this includes the governments of Australia, Canada, India, Japan, Switzerland, the UK and the US. The Eurozone is more problematic, as technically Germany does not control the European Central Bank. In this case, our theory of short term German government debt being the Eurozone's proxy for the risk free asset would rely on the assumption that any scenario that would lead to questions about Germany's default risk would also likely lead to the breakup of the Eurozone, and Germany recovering its ability to print its own currency. More broadly, the question of government default risk, in the absence of the monetization of debt via money creation by the central bank, requires that a number of factors related to economic growth potential and government fiscal management be taken into account. In terms of economic growth potential, the two most important factors are future demographics and the expected future rate of productivity growth (with plenty of subsidiary factors that contribute to these two). In terms of government fiscal management, in our view key issues to assess include the classic "debt trap" factors of the country's expected real rate of economic growth, the weighted real rate of interest on the government's debt, and the size of the primary budget surplus or deficit (i.e., the balance before debt service payments). In turn, the primary budget balance is considerably affected by the state of the nation's private sector and external balances (see following article), as well as the health of its health care, pension, and tax systems. In addition, the primary budget balance is also affected by the functioning and popular legitimacy of a nation's political institutions. The latter is critical, not only because it affects a government's ability to institute reform measures needed to improve the ability to pay creditors, but also its willingness to do so, especially when a substantial amount of debt is held by foreign creditors.