Just how fragile are markets? Wellington has done a report, and the results aren’t promising. The supply and demand of liquidity are mismatched, and chaos could be right around the corner. Robin Wigglesworth explores the market’s fragility in the Financial Times, writing:
Investors have been blithely skating into the Christmas period, basking in another remarkable rally across financial markets. But the ice underneath may be thinner and brittler than many realise, as Friday’s violent sell-off showed.
The past decade has been characterised by unusually calm, strong and long stock market bounces that have occasionally been punctuated by brief but exceptionally ferocious nosedives. This is not a new observation. But there is rising acknowledgment of the phenomenon, mounting research into it and growing understanding of the drivers — even if no one seems to agree on the primary cause.
The latest exploration of this market regime came from US investment group Wellington this summer when it published a report titled “Why fragility is the new reality for the stock market”.
It makes for compelling reading for anyone feeling nervous over the fact that the global stock market has returned more than 14 per cent this year, and had gone six weeks without moving more than 1 per cent in either direction until fears over a new coronavirus variant triggered mayhem on Friday. In fact, the suddenness and severity of the turbulence is another case in point for the “fragile markets” hypothesis.
The central problem identified by Wellington is a mismatch between demand and supply of liquidity — essentially how much investors want to trade versus how easy it is to trade, which becomes particularly acute at times of market turmoil. Essentially, both the imperative to sell and the ability of markets to handle a flurry of sales has become more procyclical, leading to an increasingly painful mismatch whenever markets are in turmoil.
When markets are calm, trading conditions are largely fine. But when the quiet shatters, many investment funds are either compelled by nervous risk managers or automatically by algorithmic rules to sell.
At the same time, market-making is now virtually exclusively a game for high-frequency trading funds. When volatility rises, HFTs guard themselves by swiftly widening the prices at which they will transact and ratcheting back the size of orders they are willing to handle.
“An imbalance has developed between the supply of and demand for liquidity, and as a result we’ve seen a significant increase in the potential for the public equity market to jump from a state of calm to one of chaos,” Wellington argued in the report.
Read more here.