The following is an excerpt from the research article “Volatility at World’s End: Deflation, Hyperinflation and the Alchemy of Risk” from Artemis Capital Management LLC. Click for PDF Download
Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. The global fleet is tethered by chains of trade and investment so if one ship veers perilously off course it pulls the others with it. Our only salvation is to hoist our economic sails and harness the winds of innovation and productivity. It is said that de-leveraging is a perilous journey and beneath these dark waters are many a sunken economy of lore. Print too little money and we cascade off the waterfall like the Great Depression of the 1930s… print too much and we burn like the Weimar Republic Germany in the 1920s… fail to harness the trade winds and we sink like Japan in the 1990s. On cold nights when the moon is full you can watch these ghost ships making their journey back to hell… they appear to warn us that our resolution to avoid one fate may damn us to the other.
Volatility at World’s End symbolizes a new paradigm for pricing risk that emerged after the 2008 financial crash and is related to our collective fear of deflation. The metaphor encapsulates the unyielding sense of dread that the global economy will plunge into the dark abyss and is the source of major changes in volatility markets. Today the existential fear of world’s end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades. The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol. My argument is not that this extreme fear is misplaced but that it is mispriced. Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world’s end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.
In the face of foreboding undercurrents our US-economic ship seems to have turned course toward calmer waters. The S&P 500 index had its best first quarter in 14 years, volatility fell to a 5 year low, and bond yields rose sharply on the trade winds of better than expected economic and jobs data. Risk assets were buoyed by an orderly Greek default with the ECB’s three year bank lending program (LTRO) succeeding in reducing dangerously high sovereign yields in the Euro-zone. While I admit I don’t understand why further leveraging the Euro-banking system to the same sovereign debt that caused the crisis will fix anything in the long-run it definitely has succeeded in calming markets in the short-term. Unfortunately this has been a recurring theme and once again there is no shortage of eager financial and political middle men cheering that the worst is now over. The conventional wisdom says “do not fight the Fed” so by extension of that logic it is madness to fight every central bank in the world by fading this rally. The pace of global monetary stimulus has been astounding reaching almost $9 trillion in total expansion over the past three and a half years in the greatest period of fiat money creation in human history(1). Let me put these numbers into perspective. Collectively global central banks have created enough fiat money to buy every person on earth a 55” wide-screen 3D television (do the math).