«We are in a period of irrational complacency»

Alberto Gallo, portfolio manager and partner at the London-based asset manager Algebris Investments, doubts that central banks can normalize their policy without causing a correction.

Mr. Gallo, the world economy is expanding synchronously and volatility is at record lows. Are financial markets poised for another strong year?
Investors are very complacent, but I think it’s an irrational complacency. The market is pricing in that earnings will keep rising, volatility will stay low and central banks continue to support growth without generating inflation. The party can go on for while, but there are more and more reasons to be cautious.

What are the main reasons to be cautious, and what has changed in the last months?
Central banks are moving closer to the point where they will have to normalize interest rates. And rates might rise faster than the market is pricing in. This and next year some of the ECB board member will leave. And the new board will definitely not be as dovish as the current one.

Inflation is still very low. Doesn’t this mean that monetary policy can remain accommodative?
Inflation has been elusive 2017 but could actually re-appear this year. There are several forces that could push inflation higher. Fiscal policy in the US and in Europe is loosening with Trump’s tax programme and a probable great coalition in Germany which could result in higher government spending. And China, the big engine of global disinflation from 2012 to 2016, is now exporting inflation as prices continue to increase and the renminbi is strengthening. Last but not least, there is inflationary pressure coming from rising commodity prices.

But why should we worry? The Fed has raised rates five times and nothing happened.
This kind of complacency is actually another reason to be cautious. There is the belief that central banks will manage the transition without bumps. Over the last two years, stocks went up and credit spreads shrunk when interest rates and government bond yields rose. But this correlation is not stable. The risk is that central banks lose control over the markets. Think of the taper tantrum back in 2013 when the Fed mentioned a possible reduction of its QE-pogramme and markets were freaking out.

Haven’t the central banks learnt from that experience?
There is this wide spread belief that they have and that they are a lot more cautious in communicating today. It’s a dangerous assumption and it’s a reason why there has been more risk taking in the market.

Where is this risk taking most visible?
People are selling volatility and basically betting that tomorrow will be as calm as today. We estimate that there are over 2 trillion $ in these kind of short volatility strategies.

Why is this problematic?
We have to put this number into context. At the bottom you have 20 trillion $ in central bank balance sheets. Then you have 8 trillions worth of negative yielding bonds and 5 to 6 trillion non-investment grade bonds that trade at a yield of close to 2%. And then you have the 2 trillion in short volatility strategies. These strategies are just the top of the pyramid.

Is this the likely source of the next financial crisis?
I am not forecasting a financial crisis but the risks are increasing. The risks have shifted from the banks to the capital markets and the nature of leverage has changed. Back in 2007 investors were highly leveraged in credit products. Now they are leveraged to short volatility.

What about investor sentiment?
Investors are very bullish and become even more bullish with every day. For example, a year ago, there was still a lot of skepticism about the recovery in the eurozone, but now more people are positive, even on weaker economies such as Italy and Greece. That’s positive for these markets, but overall it’s another reason to be more cautious.

Why?
When everybody is positive and the market is going up in a straight line you do not even need a catalyst to cause a correction.

A market correction is one thing to be prepared for. But what about the risk of a economic downturn or a recession?
In the near term, I am worried about the high valuations and the belief that central banks will manage to gradually scale back without bumps. This makes a major correction very likely. A recession, however, is not in the cards over the next 12 months.

What are the medium and longer term risks?
The recent policies, such as Trump’s tax programme, increase the degree of inequality and that can cause the political system to polarize further  and populism to rise. The Brexit vote and the election of Donald Trump were just the beginning. With rising inequality there will be more anti-capitalist, protectionist and anti-free market policies.

Is the situation in the US and the UK worse than in continental Europe?
In the US and in the UK, the polarization has already intensified not least because inequality has risen faster. The UK is probably the most divided country where we are invested in. In the eurozone, the populists are not yet very strong and we have relative stability. But we are worried that in the next downturn the political landscape will get more polarized and populism will be on the rise if reforms are not implemented.

Italy is going to have general elections this year. What outcome do you expect?
For the financial markets, the Italian election is a non-event, luckily, but unluckily for the Italian people. Because the most probable outcome is a fragmented government and that would mean a lack of reforms on a three-year-horizon and no solution to the problem of low productivity growth.

What does all this mean for the positioning in your portfolios?
We are more cautious than a year ago. We hold more cash and have reduced our overall credit risk. We see more upside in equities than in credit, but overall we have reduced risks in our portfolios.

How painful are rising rates for the bond market?
The normalization of the central bank policies is going to hurt most fixed income assets except subordinated bank debt, Greece and Italy, which need higher inflation to pay their debt. That’s why we see more upside in equities.

Which equity markets do you prefer?
Within equities, we like emerging markets as we expect a weaker dollar. The most interesting sectors are energy and financials.

Where do you see opportunities in fixed income?
The overall market offers less value than a year ago. We like Europe but are underweight the US. American high yield bonds for example will particularly suffer when the tide of central bank liquidity turns. In Europe, we are two years behind in the credit cycle compared to the US and now the balance sheets of corporates are becoming healthier. We also see value in some sovereign bond issuers that are still perceived as too risky, like for example Greece.