Slow burn Minsky moments and what to do about them

James Montier August 04, 2023 06:00

We seem to live in an era of rolling financial crisis, which I suspect is the result of a massive build-up of private sector debt. Sometimes these build-ups are accompanied by very high rates of credit growth, giving rise to a credit bubble. On other occasions, the private sector debt sits simmering in the background, largely unnoticed until the collapse, when it suddenly acts as an amplifier and causes a much steeper decline than would otherwise have been the case. I call these systemic vulnerabilities “slow burn Minsky moments.” Sadly, most markets appear to carry the fingerprints of these moments today.

One of the easiest tail risk hedges to protect against this kind of looming crisis is to hold cash. However, many seem to suffer FOMO and thus cash is often shunned, although with cash rates rising perhaps this will be less of an issue. The other large group of tail risk insurance is perhaps best described as negatively correlated with the event. The most obvious is a long volatility strategy. However, whilst this is an excellent hedge, it has been a truly terrible store of value, which in turn erodes its ability to be a hedge when we are faced with timing uncertainty. Effectively, running a long volatility strategy is the investment equivalent of death by a thousand cuts.

Value versus Growth generally does pretty well during equity drawdown events, especially if Financials are excluded. It is not as good a hedge as quality versus junk, but the valuation differential today between Value and Growth suggests it has good long-term store of value potential. To me this offers the best way of dealing with the timing uncertainty created by the prevalence of our current slow burn Minsky moments.

The typical fingerprint of a slow-burn Minsky moment involves a build-up in private sector debt. This indicator fits with the Minsky-Kindleberger bubble process, where credit creation plays a major role in the emergence of a bubble. A ratio of private sector debt to GDP in excess of 150% is an important threshold. A period of rapid private sector credit growth is also a key concern, especially when combined with an already high level of private sector debt.

The good news for the U.S. is that it is not anywhere near this level of growth. While this may help reduce the fear the U.S. is experiencing a “credit bubble,” personally I find the level of debt more worrisome from the perspective of slow burn Minsky moments. For instance, let us imagine the U.S. enters a recession, something the lead indicators are telling us the U.S. is already experiencing. In this scenario, private sector cash flows are likely to fall significantly, easily turning a run-of-the-mill recession into something far more unpleasant.

The U.S. is far from alone in facing this precariously high level of private sector debt compared to GDP.

When we look around the world, we can see lots of countries that appear to be characterized by the problem of a slow burn Minsky moment: a chronic build-up of private sector debt that leaves the economic system extremely vulnerable.
France, Spain, and the UK stand out as having especially high levels of private sector debt compared to GDP.

As I have opined countless times over the years, forecasting is a mug’s game. The future is, sadly, unknowable, so when these inherent vulnerabilities actually start to matter is beyond my ken. However, those who choose to ignore their existence are playing the same game as Chuck Prince, the ill-fated CEO of Citigroup, who, back in 2007 opined, “When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”

So, what do we do? As Pericles put it so well back in the 5th century BC, “The key is not to predict the future but to prepare for it.” I often talk about the need for robust portfolios, as opposed to optimal portfolios, which can survive a wide range of possible outcomes. Assuming we do not want to follow the “just keep dancing” approach of Chuck Prince, how should we think about building portfolios when we know that systemic vulnerabilities exist?

This question takes us to a world I last visited way back in 2011, the world of tail risk hedging. I stand by the approach I adopted in that paper. To wit, there are a number of questions we must answer when we consider tail risk protection. Essentially, they are: What? Why? How?
What is the tail risk you are actually trying to protect yourself against? In general terms, the most common concern for investors is probably an equity market decline. However, for others it may be inflation. Regardless, answering the “what” question is key before deciding the answers to the next two.

The next question centers on asking “why” you are especially vulnerable to the particular risk you are trying to protect against. For example, why are you so sensitive to an equity drawdown? Perhaps you are holding too many assets that effectively underwrite depression risk. Or, why are you so worried about inflation? What is your model for inflation and why are you so sensitive to its impacts?

The “how” question should be very obvious given you have defined the risk you care about as well as your rationale for caring about it. So now, how will you actually try to implement the protection you seek? Here we need to remember that tail risk protection is as much a value (or a contrarian) proposition as anything else in investing. That is to say that you should want to purchase tail risk insurance when it is cheap and no one else is interested in owning it. Most financial market behavior is best characterized by extrapolation, which effectively ignores the reality of a cycle. Thus, the average participants demand little payment for insurance during the good times because they can never see those times ending. Conversely, during bad times the very same participants are willing to overpay for insurance as they believe the bad times will never cease.

The concept of an equity market drawdown is currently the risk that scares most investors (the “what”). We can consider the possible instruments one might use to mitigate the tail risk of equity market drawdowns.

1. Cash. This is the oldest, easiest, and perhaps the most underrated form of tail risk hedge. Obviously, in a world where interest rates have been essentially zero (or worse), the cost of this particular form of insurance has been evident for all to see. As we move to higher rates, the opportunity cost of holding cash is reduced, and its appeal may rise once again. I will not separate out bonds from cash. A bond can always be unravelled into a string of cash rates, so unless you have a different view on the path of rates from the one implied, then the two assets are largely equivalent.

2. Options/contingent claims. Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases. A prime example was the credit default swaps that were a result of the demand for collateralized debt obligations during the housing bubble of 2007. These instruments were priced on the assumption that there would never be a nationwide decline in house prices, and thus they provided a great opportunity for those who were concerned that such an outcome was more plausible than the market implied. Of course, such opportunities are far from guaranteed to exist; other classes of risk mitigation must also be sought.

3. Strategies with negative correlation to the tail risk event. For the specific type of tail risk (illiquidity/drawdown events) under consideration here, long volatility plays are often said to be negatively correlated. The simplest example of such a strategy is just to buy volatility contracts. But as I have noted at the start of the article, this strategy is the investment equivalent of death by a thousand cuts: you can haemorrhage out over time, as the roll return is usually negative. Most importantly, due to the erosion of capital over time, the ability of this kind of strategy to protect an investor diminishes massively over time. This is an exceptionally expensive form of insurance. By its very nature, it is reasonable to assume insurance will have a negative expected value but, wow, this is pricey.

All three strategies can be priced relatively easily, and we can construct valuation-based forecasts for their attractiveness. All three generally pay off in the event of an equity market drawdown, and therefore seem to offer the best way to create robust portfolios.

For the valuation-conscious investor however, cash and deep value seem to have the edge at the moment, given today’s valuations. For many risk-conscious investors, these approaches will be key to staving off the potential impact on their portfolio of a slow burn Minsky moment.

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James Montier

Member of GMO’s Asset Allocation team and a partner of GMO