The End Game for Bubbles and Anti-Bubbles
The Expert View
Featuring Diego Parrilla
Published on: August 14th, 2019 • Duration: 48 minutesDiego Parrilla, managing partner at Quadriga Asset Partners, joins Real Vision to talk about the relationship between the bubbles and anti-bubbles. He describes how misconceptions such as the market’s faith in central banks and the desperate search for yield amplify both phenomena. Parilla then reveals the biggest risk to the global financial system, his timeline for the endgame, and how investors can position defensively. Filmed on August 7, 2019 in London.
DIEGO PARRILLA: Some of the artificially high valuations on the S&P are actually mirrored by artificially low valuations in the VIX. This belief in the central bank put, this complacency is whatever it takes drives the process that I would summarize us from risk for interest to interest rate risk. The idea is to have a strategy that will do very well when you need it and the mandate is clearly first and foremost, to protect the capital.
It's good to be back. I'm Diego Parrilla. I'm a mining and petroleum engineer, originally from Spain, did my masters in Mineral Economics at the Colorado School of Mines and the French Institute of Petroleum. Started my career in the mid late '90s in investment banking, always within the macro commodity space- JP Morgan, Goldman Sachs and Merrill over New York, London, and Singapore. In addition to that, or following that, I moved on to the buy side, where I've had my own firm, and I've had the privilege to work for some of the large macro players such as BlueCrest and Dymon. And in addition to my experience on the buy and the sell side, I'm also a best-selling author.
What are anti-bubbles?
So, first I mentioned of the anti-bubble is the fact that we're talking about assets that are artificially cheap. We're talking about assets that it's a matter of when, not if that the value will go up. So in that sense, we're talking about wider definition of value in a way. In addition to this idea of artificially cheap assets, there's a second dimension that is very important, and it's the fact that bubbles are a bit like distorted mirror images of the same misconception. So, in that sense, they are actually two mirror images of the same effectively false belief. And as a result by construction, the moment, the instance when the bubble bursts is also exactly the moment where the anti-bubble reflects.
So, in that sense, we're talking about synchronous timing, synchronous catalysts, because effectively, they're two reflections of the same process. So, we could think about anti-bubbles a bit like an antivirus or an anti-missile as a defense mechanism, as a hedge against the bubbles. So in addition to these first dimensions of assets that are grossly artificially cheap, and also a hedge against the bubbles, there's a third dimension that is important. And this is effectively the fact that bubbles and anti- bubbles are in a way, the same. They're interrelated. They feed on each other.
So, we're talking about a symbiotic process whereby, as an example, I would argue that some of the artificially high valuations on the S&P are actually mirrored by artificially low valuations in the VIX. The relationship between the S&P and the VIX is a clear bubble-anti-bubble relationship. They're not independent processes. They're related as we'll discuss later. They're related not only qualitatively through the perception of low risk and complacency, but also quantitatively through low volatility feeding into positioning for CTAs and signals.
What's ironic and part of the opportunity here is that nobody wants to buy puts on the S&P at 3012 vol, but then everybody will want to buy puts at 2340, 2360 vol. So it's a bit ironic that the market is giving you insurance the cheapest when you actually needed the most. So, in that sense, the third dimension is the idea of risk premia. It's how the market is compensating us for taking the other side and how you make sense to be loading up on anti-bubbles such as the VIX or financial insurance when the market needs the most.
So these three dimensions, whether it's anti-bubbles being grossly artificially cheap, effective hedges against the bubbles, and also sorts of risk premium makes it quite a powerful concept, which I'm pleased to say has been embraced widely in the industry. And that I think is one of my small contributions that I'm thankful for.
What misconceptions feed bubbles and anti-bubbles?
So having looked at the concept, the generic framework of bubbles and anti-bubbles, let's look at the beliefs that, in my view, are misconceptions. They're perhaps widely accepted, but they may not be necessarily true. And as a result, what are the bubbles and anti-bubbles we've created, and where are the opportunities and risks? And I like to summarize or break it down in two pieces. Let's start by the first one, which is the belief in the central bank put.
I define the central bank put as the belief, in my view, misconception that central banks and governments or mommy and daddy, as I would call them, are infallible, in full control, and they can actually print and borrow their way out of any problems. This belief is very deeply entrenched into investors' mindsets, it takes many names, is never fight the Fed, it's Draghi's whatever it takes, it's PBOC is in control. And it actually feeds into sub-beliefs, which we're going to go in more detail later.
One is the sub-belief that monetary policy has no limits. You can literally print your way out of problems, which goes hand in hand with the idea that you can borrow your way out of problems, which is the fiscal side of the equation. Now, as a result of this belief and this perception that mommy and daddy will always be there to support us and support the markets, you could summarize this into one word, which is complacency.
What we've seen through Q4 is a significant shock to the markets where mommy Fed came in again very aggressively and in fact, we saw prices making new all-time highs in the process, effectively feeding on this misconception. However, Q4, in my view, set a change, complete game changer in the dynamics of the markets including the end of the normalization, which has led to their first cut since 2008. So, this first belief, which is in some way, a financial Boolean, we've seen artificially low interest rates, has led to a second group of beliefs and behaviors.
The second group is what I would define as the complacent desperate search for yield. What it means is we, as investors, have been incentivized or perhaps rather forced to take more risk, and we've grown accustomed to this yield and will do literally whatever it takes, investor version, to reach that. I'm from Spain, in Europe, barely 10 years ago, my mom, or our moms could put their savings in 1-Year AAA unlevered instruments and earn their 5%, that picture has dramatically changed. So, what it's done, it's effectively created this process, which all starts with the first, with the origin, which is cash at zero or even negative rates, and what it means for one of the first bubbles and most important bubbles in the system, which is duration, especially in the government bond space.
So, what we've seen here is that investors, we've been- with QE and artificial demand, the infinite demand for bonds and others and monetary policy moving further out, we've been basically increasing duration, we've been thinking lending for longer and longer for lower and lower. And this has reached key milestones. Just a few days ago, we saw 30-Year Bunds trading negative for the first time in history, we had seen prior to that the entire curve in Switzerland 50 years trading negative. And this is a dynamic that is obviously very contagious and very worrying for the markets. In fact, as an investor, we've taken incremental amount of risk in ginormous quantities and volumes in markets, and people don't really understand how wild this could be. And this is part of the problem.
So, this first issue with the duration bubble feeds into the second one, which is obviously credit. The idea that if a AAA bond is paying zero or negative and I need to go 30 years plus to get yield, obviously, investment grade or others start to look better. So people, what we've seen is a process where we've been lending to weaker and weaker credits for longer and longer for lower and lower. And this is a textbook bubble, unlike the bubble in duration in government bonds, which is the epicenter of the problem but not necessarily the problem itself.
The credit starts to be a much bigger issue. And what we've seen is- gets lost is about 13 trillion in negative yielding, but obviously, very worrying how that's spreading into the corporate space and farther out. So, that's not just the investment grade, it's moved on to higher yield, and obviously, to emerging markets. So, we have this ginormous problem in bubble in my view, which I'll come back to later, because this is an area to avoid.
Third, not only fixed income duration and credit, we look at equities. So, what you see is a political parity relationship between bonds and equity. We're looking at assets with a very complacent view of the future. The future discounting cash flows are artificially low rates with very high multiples with buybacks with all the issues that we're familiar with, talking about earning per share and other dynamics. So, the epicenter of the problem is duration, is artificially low rates that's led to enormous program, obviously, on the credit, but this moves into equities.
We're looking at highly complacent expectations of the future, which we're discounting an artificially low interest rates, artificially low credit spreads, artificially low volatility with corporate buybacks, and the wrong way to measure whether it's earnings per share, where sales and others, so things that Real Vision subscribers are very familiar to. So, arguably, we have this problem building on the public equities, but goes further. We go into a fourth part of the problem, which is the private side. So, the number of people have told me, yeah, maybe public equities and credit are expensive, but we're capturing the liquidity premium of the markets.
I'm quite concerned about this, I think this is just the desperate search for yield pushing down into this category of illiquid investments. Not only the private equity, but more worryingly, private credit and everything that's happening off of the system and in shallow. In fact, this is one of the areas that's very obscure in every financial crisis, tends to have some of the financial engineering which here comes on the monetary side with QE and LTROs and with all the acronyms, but I think there's also an issue on the private liquidity which we will view.
And then we go into leverage. So with interest rates low and arguably there for a long time and risk arguably also low and this desire to get this high returns, so we have a lot of leverage in the system. So as a result, we have this series of parallel synchronous bubbles, whether it's duration in credit and equity and liquidity and leverage, which as a result, what we're seeing is a process where my mom, as I said earlier, was earning her 5% in 1-Year AAA unlevered, today, to get the equivalent yield, she would need to go way lower, BBBs, CCCs, whatever, further out and with some leverage and even then, she would struggle.
This process effectively took to- we're building the house for the roof. And instead of going to the market, and saying, hey, I want to take X amount of risk, how much do you pay me for it, we're going to the market and saying, hey, I want my 5%, tell me what I need to do. And this effectively series of parallel synchronous bubbles are creating this problem, which is hiding one key risk in the system, which is the risk of false diversification. I cannot stress this big enough. The risk of false diversification is confusing, having a lot of things in your portfolio with being diversified. In this case, you might see how all these portfolios during periods of stress might behave just as one.
So, in that sense, putting that all together, this belief in the central bank put, this complacency, this whatever it takes government and central bank with the whatever it takes investor, the complacent desperate reach for yield drives a process that I would summarize as from risk for interest to interest rate risk. And this is a dynamic that has created this series of parallel synchronous bubbles, but it also has this mirror image, which is the anti- bubbles.
Can you identify any anti-bubbles for us?
So, what are the anti-bubbles? What are the mirror images of this process? The most important one, in my view, is volatility and insurance, financial insurance. So, the mirror image of this complacency has been expressed in gross imbalance in the supply and demand of volatility and insurance. And therefore, we've seen artificially low levels of volatility. What it implied and realized. What you see, and this is very dangerous, is artificially low volatility means artificially low VAR- value at risk, is the equivalent of driving your car at 200 miles an hour when the speedometer says 80. If you ever had an accident, what would you feel? Well, you would feel the real speed, you will run regardless of what the speedometer said.
In that sense, volatility is a bit like the speedometer of the markets. You might see a certain price action, a perceived amount of risk, but the reality is that the real risk you run in is the risk you're running. So, in that sense, a lot revolves around artificially low volatility. There is part of it, which is qualitatively which is this complacency. But there's also the desperate search for yield, which is people selling volatility systematically in many ways, structured products, covered calls, naked puts, worth stops, and also indirectly through CTAs and risk-parity- another type of strategy. So, there's significant hidden leverage through artificially low volatility that it's very constructive on the way up, but you can expect very badly.
There's a second anti bubble that is very important, which is correlation. Correlation has been also artificially low. So on a day to day, you might see the perception that your Amazons and your Argentinean bonds and whatever are uncorrelated, but during periods of stress, these assets then- correlations then to go to plus one or minus one. What happens when you put those two things together, which is portfolios that have artificially low volatility and artificially low correlation might look like your level of risk is very flat. However, when things go wrong, effectively, you see two dynamics, you see the volatility of the portfolio increasing substantially, but also the correlations.
So, you go from the perception that you have very little risk to ginormous risk and this compounds, because what you see is that as volatility goes up, and your correlations increase, your value at risk goes up exponentially, geometrically. As a result, you see forced liquidation. So, what happens is all these CTAs, all these buying that feeds into this bull markets with strong trends in low volatility can reverse very wildly. And this is part of what happened in Q4 and what we will see again. So, you need to watch out for these spikes in volatility, because they feed on themselves, not only through volatility, but also correlation.
The third problem we're going to face, which we were very close in Q4, and in my view, explains the dramatic change in the Fed is liquidity. We saw GE and other companies, other bonds under pressure, equities, I think we were pretty close to spinning out of control. And we were lucky that those liquidity events didn't happen. We have seen a number of funds in Europe and other parts calling for gating. This is a huge warning. See the similarities with 2007 with the Bear Stearns and BMP funds, so we will connect the dots after the fact but there's a lot of hidden risk in the form of perceived liquidity, low volatility, low correlation.
And this could eventually lead to reflexivity. So, as effectively the markets collapse, you see how people are forced to respond, layoffs, and et cetera. So, this is a process quite dangerous that we need to watch carefully, and eventually leads to perhaps the third and one of the key anti-bubbles, which is gold.
Why is gold important with anti-bubbles?
All this dynamics of volatility and correlation feeding into potential liquidity and reflexivity explain why we will see a very aggressive monetary and fiscal response, mommy and daddy back to the rescue. And I see gold as one of the key anti-bubbles in the system. Front page article of the FDA was calling 3000 to 5000 gold in three to five years. It really sounded like science fiction at the time, less so these days. But there's a number of artificially cheap assets on the monetary side where gold, I think, is particularly well suited. So, we have these two dynamics of a series of parallel synchronous bubbles on