El-Erian: “All This Could Lead To Some Unpleasant Market Outcomes”

Monday, May 15, 2017
By Paul Martin

by Tyler Durden
ZeroHedge.com
May 15, 2017

Stability breeds instability – this was economist Hyman Minsky‘s lasting contribution to the craft. The Minsky Moment , popularized during the 07-09 US housing crisis, basically suggests breeding animal spirits too long creates systemic problems. Essentially, the ongoing rises in asset prices creates the sense of a new paradigm, that the elevated activity was safe, and home prices couldn’t fall.. that didn’t end well.

And, as Mohamed El-Erian writes for Bloomberg, excessive stability breeds instability down the road.

The smoother the road, the faster people are likely to drive. The faster they drive, the more excited they are about getting to their destination in good, if not record time; but, also, the greater the risk of an accident that could also harm other drivers, including those driving slower and more carefully.

That is an appropriate analogy for the way unusually low financial volatility influences positioning, asset allocation and market prospects. And it holds for both traders and investors.

The lower the market volatility, the less likely a trader is to be “stopped out” of a position by short-term price fluctuations. Under such circumstances, traders are enticed to put on on bigger positions and assume greater risks.

What is true for one trader is often true for firms as a whole. Moreover, the approach is often underpinned by formal volatility-driven models such as VAR, or value at risk, that give the appearance of structural robustness.

Patient long-term investors can also be influenced by unusually low volatility, whether they know it or not. Expected volatility is among the three major inputs that drive asset-allocation models, including the “policy portfolio” optimization approach used by quite a few foundations and endowments (the other two variables being expected returns and expected correlation). As the specifications of such expectations are often overly influenced by observations from recent history, the lower the volatility of an asset class, the more the optimizer will allocate funds to it.

The Rest…HERE

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