Equilibrium and Transition

Economics suffers from physics envy and often attempts to model the world with the precision of classical physics, which of course cannot be done.  What one can do, however, is to look for analogies between complex evolving systems, human behavior and the economic ecosystem. Predicting economic and financial market outcomes is very uncertain (think about meteorology) and we must recognize the importance of the initial conditions of a system while attempting to forecast and to understand outcomes in both natural phenomena and economic phenomena.  In short, recognizing a chaotic path dependence anchored to the initial state and the attractor (think of a single factor that influences the entire system) of a complex system.

Presently, in the major developed economies the initial state (expectations) are for low growth, artificially low interest rates, thanks to global quantitative easing, and continued disinflation, if not outright deflation. Investors and economic agents have their behaviors, and their asset allocations decisions anchored to these initial conditions. Right or wrong, this is our "equilibrium condition" which until recently has been unquestioned for the last few years.

In last few months a butterfly has been flapping its wings in Japan and has agitated financial market conditions throughout the globe.  In fact, the objective of the current policy of the Bank of  Japan is to move the deflationary expectations away from the actual "equilibrium" state to a new state of inflation. Change in a system or a condition is not usually instantaneous, heat must be applied to ice in order to transition to water in the liquid state : the water molecules must become "volatile". The financial markets were crystallized in a low volatility environment in which the status quo was the discounted future outcome and now have begun to transition to a new and yet uncertain equilibrium state.

In the month of May the bond markets around the world had their worst monthly performance in four years as investors began to rethink how a different future (one not previously considered imminently possible) might effect portfolio returns.  The BOJ has ignited a flame on bond market volatility and the FED,  which has raised doubts in the mind of market participants about the flow and sustainability of quantitative easing, has turned up the flame, accelerating the transition to a new initial state with new expectations.

The markets were in a state of low or negative real yields, very low absolute yields, compressed credit spreads and low liquidity premiums.  In short, all the sources of risk premiums were reduced or non existent.  Passing from this condition to one in which the markets will require compensation for risk has been facilitated by selling in all segments and geographic regions of the bond market and in all currencies, especially those for which no expectations for depreciation were incorporated.

The future paths for this chaotic, deterministic system are uncertain but we can arrive at possible scenarios if we keep in mind from which initial conditions we are transitioning. In evaluating possible outcomes, and positioning a portfolio,  it is more important to understand what expectations are discounted in present valuations (initial conditions) than forecasting the timing and the precise levels of yields, prices or indexes.