Kolanovic Says Machine-Made Liquidity Will Fail in Next Crisis

(Bloomberg) -- One day the bull market will end. And when the crash comes, machines will play a starring role.

So says Marko Kolanovic, which should surprise nobody. The JPMorgan Chase & Co. derivatives strategist has warned for years about structural risks tied to quant traders, electronic market makers and passive funds. The 43-year-old New York University PhD is one of about 50 analysts at the bank who contributed to a 170-page retrospective on the 2008 financial crisis. His section is titled, “What will the next crisis look like?’’

In Kolanovic’s view, the most probable catalyst for the next disruption is the withdrawal of the measures put in place to halt the last one. When central banks drain the punch bowl and reverse asset purchases intended to prop up the global economy, another financial crisis may follow, according to him.

“We will call this hypothetical crisis the ‘Great Liquidity Crisis,”’ he wrote. “The timing will largely be determined by the pace of central bank normalization, business cycle dynamics, and various idiosyncratic events such as the escalation of trade wars waged by the current U.S. administration. However, timing of this potential crisis is uncertain. This is similar to the 2008 GFC, when those that accurately predicted the nature of the GFC started doing so around 2006.”

But while the removal of central bank stimulus will ignite it, everything will be made worse by a host of forces that have long populated Kolanovic’s enemies list. They include:

• The rise of passive investments like exchange-traded funds, which reduce “the ability of the market to prevent and recover from large drawdowns;”
• The rise of funds that adjust holdings automatically according to market conditions, meaning they “programmatically sell into weakness;”
• A shift from human market makers to “programmatic liquidity” that relies on volatility-based value at risk to adjust risk taking;
• The failure of other assets, most notably bonds, to offset plunging equities, due to low rates and central banks’ extended balance sheets that crimp their ability to make asset purchases;
• Pension funds’ reallocating money from stocks to private equity;
• Ballooning valuations as a result of nine years of policy accommodation, and;
• The rise of populism, protectionism and a trade war.

A rebuttal to all this might be, why hasn’t another crisis already happened? After all, none of those forces is particularly new and markets have absorbed many body blows since 2008. While nobody considers episodes like the yuan devaluation or Brexit pleasant, none resulted in an extended panic like the last one.

In fairness, crash scenarios are a small section of a sprawling note assaying causes and effects of the financial crisis, everything from ballooning public debt to impaired growth to lower inflation. Parts of it are relatively sanguine, including predictions that the next recession will be shallower amid few signs of a housing bubble. Kolanovic’s section addresses hazards in markets, so it’s not surprising that’s what he details.

Kolanovic doesn’t make a guess on when it will all go south, but in a note issued in July he said the bull market, now the longest ever by some measure, could run until 2020. His point is that when the drawdown comes, it will likely be exacerbated by the rise in passive and mechanical investment. He’s particularly bothered by a $2 trillion rotation from active investing strategies to passive ones since the financial crisis.

“The shift from active to passive asset management, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns,” he said in the note.

Most of the concerns expressed by Kolanovic about the state of liquidity are a reiteration of points he’s expressed in the past, though he hadn’t previously spilled much ink about the rise of protectionism and populism. The next financial crisis will likely result in social tensions similar to those witnessed in 1968, when baby boomers got access to “unfiltered” information about income inequality, the civil rights movement and developments in Vietnam.

“Similar to 1968, the internet today (social media, leaked documents, etc.)
provides millennials with unrestricted access to information on a surprisingly similar range of issues,” he wrote in the note. “In fact, many recent developments such as the U.S. presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis.”

The S&P 500 Index has advanced 11 percent since Kolanovic made a bet on the U.S. stock market recovery in March.

To contact the reporter on this story: Elena Popina in New York at epopina@bloomberg.net

To contact the editors responsible for this story: Courtney Dentch at cdentch1@bloomberg.net, Chris Nagi, Eric J. Weiner

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