By Eric Peters, CIO of One River Asset Management
“Following the 2008 crisis, there was this well-intended, monoline focus on banks becoming safe,” said the CIO, high atop his prodigious pile. “The thought was that by making banks permanently safe, we could effectively eliminate systemic risk,” he said. “That’s wrong of course, but not for obvious reasons.” Following each financial crisis, the politicians, regulators, and policy makers strive to ensure that we never repeat the debacle, which inevitably appears obvious in hindsight. They usually succeed, and in so doing, sow the seeds of something novel.
“Removing the possibility that banks would be the source of risk in the financial system required that regulators prevented them from having flexible balance sheets,” continued the same CIO. “In a market decline, banks used to be able to buy distressed assets.” Expanding their balance sheets, absorbing panic selling by their clients, taking on market risk. “But they can no longer be a buyer in periods of market stress. And the regulators think this is fine, because the risk is transferred to investors and speculators, none of whom threaten to the broader system.”
“But the issue of course, is that the risk in the system has been transferred from banks to asset managers,” he said. “And asset managers do not have flexible balance sheets.” In an industry that has grown to be dominated by passive, long-only products, asset managers simply buy assets when they get inflows and sell assets when they get outflows. They do not have the ability to expand their balance sheets when assets are being sold at distressed prices. No such mechanism exists. “In today’s system, the shock absorber is the asset price.”
“In a system where price is the shock absorber, we should expect very large price moves, and the need for the central bank to step in and support markets becomes more obvious in a crisis,” he said. “But given today’s inflationary backdrop, policy makers cannot be seen to react quickly. They won’t bend early, they simply can’t,” he said.
“I’m growing extremely concerned about the market. Bearish sentiment remains awful. But despite this, the rallies are getting shorter, sharper, whippier. We’re getting close to a broad liquidation point for markets.”
“Most people remain focused on bearish investor positioning,” he said. That measure has been helpful for years; but it was in a disinflationary period with QE in the background, Fed puts, plunge protection teams. “Traders are fearful of missing the turn, the bounce, the Fed pivot. It is all micro focus; they’re chasing their tails. They underestimate the impact of rapidly contracting liquidity; today’s novel flow into reverse repos. They miss things like UK pension margin calls. No one appreciates the risk that the market runs out of oxygen.”