Morgan Stanley
- Statistically, surprises are increasingly becoming unsurprising across all asset classes, according to Morgan Stanley
- A big part of the reason: Investment assets are becoming less liquid.
- Veteran traders will not like this one bit. Lots of surprises + low liquidity were the fundamental triggers of the 2008 crisis.
LONDON - Facebook stock fell by 24% at one point last week, a move that helped wipe 1% off the NASDAQ on the day.
Investors were surprised. FB has been one of the best-performing stocks of the last few years.
But Morgan Stanley analyst Andrew Sheets and his team says that big unexpected moves in asset classes like equities should not, in fact, be all that surprising. That's because, statistically, surprises are increasingly becoming unsurprising. (My colleague Joe Ciolli noticed this last week.)
In 2018, surprise moves across all asset classes - stocks, bonds, commodities, currency etc - are becoming almost as frequent as they were in 2007 and 2008, the years of the financial crisis that produced the worst global recession since the Great Depression.
A big part of the reason: Investment assets are becoming less liquid.
That's a very worrying sign for asset markets.
REUTERS/Nacho Doce
Let's talk about the lack of liquidity.
The world certainly feels more surprising - Trump, Brexit, North Korea, Facebook falling off a cliff - but the Morgan Stanley team wanted to know if the markets were actually becoming more surprising. So they did some very clever mathematics.
Looking across asset markets (all the above plus currencies), they compared moves in the market versus expectations implied by futures options on those markets. Then they counted all the moves that were at least "three sigma," or three standard deviations from the mean. Very broadly, 68% of results in a set of variables will occur right near the middle of a bell curve; 95% will occur within two standard margins from the mean, and 99.7% within three. So any results outside 99.7% of all results are regarded as a surprise vs. expectations. It is those "surprises" that are occurring more frequently.
As the chart above summarises, we're on course for a year that contains as many big surprises as 2007.
That was the year that brought us the global credit crisis.
Market liquidity across assets is in decline
MS also has a worrying explanation for why surprises are becoming more frequent: Market liquidity across assets is in decline.
One way to think about "liquidity" is that it describes the ability of a market to get out of trouble. Let's say you are trying to sell a bicycle. If 10 people offer you $100 for the bike, you have a nice market. You can sell the bike for $100 and 90% of the market will be unaffected. Plus, nine other people can find buyers for their bikes, too. This market is liquid.
But if only one person wants to buy your bike, and she offers you $10, then you've got a problem. Selling the bike will wipe out 100% of the available market. The nine other bike sellers behind you are stuck with bikes worth $0. There is no liquidity.
That is what's happening in global asset markets right now (and it's what happened when financial markets collapsed in 2008), Sheets says. "This isn't the problem of a single asset class. It's everywhere."
As an example, he cites primary bond dealers, whose market share of company bonds is one-tenth the size it used to be - implying that they have fewer assets to sell if need be:
"Dealer holdings of corporate bonds have shrunk from 3% of the market to just 0.3% today. While this means that dealers themselves have less to liquidate, their capacity to move risk to a new buyer may be limited and require larger repricing of the asset class in times of stress."
"Forces are now swinging in the other direction"
And central banks are selling bonds in order to increase interest rates. That is creating a market with fewer buyers and more sellers - the definition of illiquid:
"As central banks built these positions, liquidity in the affected assets was excellent. It's hard to imagine anything better for liquidity than the presence of a steady, deep, well-telegraphed bid. But these forces are now swinging in the other direction. The Fed's purchases have already begun to reverse, the ECB's are likely to over the next six months, and with close to half of its bond market already owned by the BoJ, it will eventually face a constraint."
Veteran traders will not like this one bit. Lots of surprises + low liquidity were the fundamental triggers of the 2008 crisis.