Executives have taken to using the military acronym
VUCA–Volatility, Uncertainty, Complexity, Ambiguity–to describe the
world in which they operate and to ask that question: In a VUCA world,
what’s the point of strategy?
Strategy does still have a purpose, but building one in a VUCA
environment requires more nuanced thinking. And treating those four
traits as a single idea leads to poorer decision making.
Watch and
listen as Nathan Bennett provides a framework, first featured in an HBR article, for how you should deal with a world that includes V, and U, and C, and A.
As some prices overshoot in the downward
direction, as they inevitably do, investors will come across
opportunities that they previously could only hope for.
By Mohamed A. El-Erian
FORTUNE
-- Liquidity shocks, like the one currently cascading through global
financial markets, are unpleasant, and frustrating. They can be
indiscriminate in their impact, as is the case today. They are hard to
explain rationally and, as such, can become incapacitating. Yet, they
often create interesting opportunities for those that understand the
underlying dynamics and know where to look.
Here is a simple way to think about the phenomenon. Suppose we are
sitting in a room where the oxygen is suddenly sucked out. It is likely
that we will ALL eventually end up on the floor gasping for air, and
this will occur regardless of our initial physical condition (a key
point). Yet this uniformity of physiological response will likely not
persist once the oxygen is gradually restored (and provided it doesn't
take too long). Some will recover relatively quickly. Others will face
more prolonged challenges. And a few may never recover.
Well, that is how financial markets work when there is a sudden and
substantial withdrawal of liquidity. The situation is remedied in two
ways: The horrid market technicals eventually exhaust themselves and/or
market participants with healthy balance sheets (private, public, or
both) step in to provide stabilizing liquidity.
In the meantime, you get what economists call an adverse multiple
equilibrium -- rather than mean revert, a bad outcome increases the
probability of an even worse subsequent outcome. So markets overshoot on
the downside beyond what would be warranted by fundamentals; and such
overshoots can be considerable in the context of excessive market
exuberance going into the liquidity implosion.
MORE: Ultra-low interest rates are making bonds unsafe
Over the past few weeks, we have been monitoring the emergence of such dynamics (See What the markets are trying to tell us). The
fuel was the excessive disconnect between financial prices and
fundamentals. The proximate market spark was concern that the underlying
wedge -- that is investors' excessive faith in the power and
effectiveness of central banks -- was being undermined by signs of
policy inconsistency and less-than-stellar economic data (See A lot is riding on U.S. jobs data).
The liquidity dislocations initially hit the most levered and less-liquid markets (e.g., emerging markets,
including local and corporate debt, and high-yield bonds). They were
visible in wider and volatile bid-offer spreads, diminished willingness
on the part of dealers to make markets, and investor concerns that
exiting the market was no longer as viable an option as previously
thought.
The resulting turmoil, including price gapping up and (more often)
down, triggered reactions that gradually transmitted the dislocations
throughout global markets. The cascade has been at first, gradual and
sequential, but there is a risk that it could become disorderly and
indiscriminate.
It is no longer just about emerging markets and high-yield, nor is it contained to the currency markets
where the Yen has been particularly unstable. The phenomenon is now
evident in investment grade bonds and inflation linkers. It is just a
matter of time before it hits hard European government bonds,
particularly the weaker economies. Absent a circuit breaker, it could
well spread to U.S. and European equities.
The vast majority of asset allocation approaches are challenged in
such circumstances, especially as traditional correlation matrices
suddenly break down. Volatility and VAR-related trading strategies are
hit particularly hard, forced to reduce leverage into liquidity-strained
markets. Outflows from mutual funds and other accounts accentuate the
disruptions, as do crossover investors who had ventured deep into
off-benchmark asset classes and are now scrambling to get closer to
benchmarks.
MORE: Jamie Dimon: Prepare for more volatility
Yet there is a notable upside that accompanies the general sense of
anxiety and havoc. As some prices overshoot in the downward direction,
as they inevitably do, investors will come across opportunities that
they previously could only hope for.
The key is to identify those anchored by solid fundamentals,
even if the anchor is obfuscated for now by nasty market technical. And
it is essential to size and time these trades appropriately as further
volatility could well materialize.
Already we are witnessing the emergence of value again in certain
segments of the emerging markets (e.g., local bonds in the highest
quality emerging countries and, external credit -- sovereign, quasi
sovereign, and some corporates -- in economies with massive reserve
cushions and virtually no debt), parts of the yield curve in government
bond markets in advanced economies (including the intermediate part of
yield curves), and certain short dated volatility trades.
Successfully navigating today's volatile market environment and
effectively seizing market opportunities requires a combination of
careful risk management, an analytical framework that separates signals
from noise and, yes, intelligent courage.
Investors combining resilience and agility should expect an expanding
set of overshoot-related opportunities to emerge in the period ahead,
especially as the current market instability may well need some time to
reach the point of natural exhaustion or liquidity interventions.
Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO.
