The latest generation of professional investors got their feet wet in the wake of the 2008 Global Financial Crisis. For nearly a decade and a half after the collapse of Lehman Brothers, central banks sought to restore faith in the financial system.
They suppressed volatility and subsidised investments by keeping rates very low while regularly infusing markets with cash. Central bankers became compelled to evolve their “put” (stabilising markets in times of volatility) from a vague promise to an immediate and real-cash response, in the form of quantitative easing.
In the case of Europe, the ECB took it a step further, underwriting the currency union and keeping states solvent.
In that post-GFC world, volatility was the enemy that central banks sought to quash. But what the Fed could not publicly acknowledge was their open preference to step away from the put-trap.
They never wanted to promise a perpetually better risk/reward profile for financial assets, especially at the expense of the real economy. However, post-GFC fears forced their hand. Fifteen years of financial repression turned the central bank put from a promise into an obligation, lest they risk a financial meltdown.
The Fed and the ECB were, essentially, shackled to the whims of financial markets
And then, that changed.
That same investor generation was shocked in 2022 when the Federal Reserve prioritised the fight against inflation (its primary mandate) embarking on a steep rate tightening cycle and pulling the other central banks with it. The pandemic and the inflation crisis became a litmus test on how the system can function under stress without frequent central bank intervention.
Two and a half years where the put did not translate into cash at every sign of volatility (with the exception of the US peripheral banking meltdown in March 2023), saw the equity market not only survive but reach new highs.
Financial markets passed with flying colours, proving to central bankers that they no longer need to suppress volatility.
So, the financial world became inherently more volatile.
Meanwhile, volatility is inherently also increased by factors external to the financial system. Lack of fiscal space and sluggish growth are pressuring consumers, who are strapped for cash and often inflamed by social media about what they perceive is a better standard of living for “others”, to turn to more populist policies.
Nationalist populism, what Dr Benjamin Spock used to call “hugging the flag” in times of uncertainty, has been on the rise in developed countries, with its adherents preaching de-globalisation as a solution to economic woes.
Reduced cooperation between countries and trade wars make global supply chains less efficient, more expensive and, ultimately, more inflationary. Given the very elevated levels of global debt, persistent inflation scares mean that interest rates might need to be kept higher than they would otherwise, increasing interest payments on debt, further reducing fiscal space and at the same time increasing the cost of money, draining markets from cheap cash.
So how do investors deal with this structural increase in risk?
