Investors beware: central banks won’t be able to prop up markets forever

As human beings, we already have a tendency to assume that tomorrow will be the same as today. It's one reason that momentum investing (buying what went up yesterday and selling what went down) pays off.

Today is often the same as yesterday, so this approach works until it doesn't.

One reason that we take out insurance is to guard against this tendency. Unfortunately, the more complacent we get, the less need we see for insurance.

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And that's where markets are right now.

Trump vs China is just a symptom of our changing world

Investors are still betting that Donald Trump and China will come to some sort of agreement on trade, even if Trump's Friday deadline for higher tariffs comes and goes.

Stockmarkets haven't been overly battered by the news this week (China has taken a big hit, but China's market is pretty volatile at the best of times, partly because many of its participants view it as a massive roulette wheel).

Markets aren't necessarily wrong on this. Investors haven't yet seen the fallout from the existing tensions (trade has suffered in recent months, but mostly for other reasons so far). And there's an assumption that a deal will be reached because it's in everyone's "best interests".

I could certainly construct a scenario in which Trump sees it as in his best interests not to have any deal at all ("us vs them" is often a good way to win an election and if he doesn't expect any economic damage from tariffs then maybe this route would appeal).

But this isn't really the point. The point is more that in the longer run even if a deal gets done here the world is shifting to one which is very different to the one markets have grown used to over the past several decades.

And it's pretty clear that investors as a group are not ready for that.

One big danger, as the blogger Blonde Money points out, is that we're experiencing more political volatility at a time when the financial world is heavily "short" volatility.

What does that mean?

Markets are too confident that tomorrow will be the same as today

The details of the topic are quite complex, involving lots of derivative terminology. But the headline story is really pretty simple. Put simply, markets are too confident that asset prices will keep going up at a relatively steady, stately pace. As a result, markets (consciously or not) are effectively banking on the idea that there won't be big disruptions along the way.

My own view (and it's hardly unique) is that this bias towards shorting volatility is a direct result of decades of the "Greenspan put". For those who haven't heard me rant about this before, the Greenspan put refers to the implicit understanding that central banks will do what they can to prevent big falls in asset prices.

It's named after Alan Greenspan, chairman of the Federal Reserve, the US central bank, who created this (unofficial) policy. The "put" refers to the language of options trading if you buy a "put" option, it gives you the right to sell an asset at a given price to the person who sold you the option. In other words, it acts as insurance if the S&P 500 falls to 2,500, but you have the option to sell it at 2,700, you're sorted.

So the "Greenspan put" implies that the entire market is insured against a drop. And if you have an apparently all-powerful central bank underpinning asset prices, then why would you pay anything yourself to insure yourself against a fall? As the Blonde Money blog puts it: "As shocks have become fewer and shorter, paying for insurance just becomes a drag on the performance of the portfolio".

In fact, why not sell insurance yourself and make a few pennies on the side? After all, if someone is stupid enough to buy insurance against an event that's never going to happen, why not take advantage of them?

So that's the thinking behind it. You end up, notes Blonde Money, in a "world where positions are skewed too far from the reality of risk'."

Hefty overconfidence in markets is never great news. But it's a particular problem now, because the world is slowly but steadily moving into an environment where the "Greenspan put" won't be sufficient to shield markets from upheaval.

Central banks won't always be able to rescue investors

Markets are used to a world in which the biggest risk is deflation, which central banks can combat through money printing. Markets are used to a world in which individual governments don't matter, because politicians and their views on economics are essentially interchangeable. Tax might be a headache for employees and small businesses, but not for the globally mobile.

Anyone with their eyes open can see that this world is changing.

Politicians are becoming more interventionist. Borders are likely to become less porous as a result. The freedom of movement of people is already being challenged and has always been the most controversial. But the freedom of movement of goods is now being challenged too, with tariffs.

And in the longer run, expect more explicit discussions about the freedom of movement of capital. A crackdown on global taxation is just one manifestation of this. A return to capital controls under certain governments is a very real possibility.

On top of this, policy is becoming more inflationary. Globalisation created our disinflationary world. Turning away from globalisation will change that. Moreover, policies such as "QE for the people", or "MMT", or even a basic income, all point to inflationary fiscal policy, coming on top of full employment and rising wages.

This is a very different world. And it's one that markets aren't ready to confront. That could spell fireworks when investors wake up.

We'll have a lot more on political volatility, and its impact on the UK specifically, in upcoming issues of MoneyWeek magazine. Meanwhile, for more on Brexit and its potential effect on businesses, check out this piece (written in association with currency specialists OFX) How to make Brexit work for your business.