Slow Burn Minsky Moments (and what to do about them)

Executive Summary

We seem to live in an era of rolling financial crisis. I suspect this is the result of a massive build-up of private sector debt. Sometimes these build-ups are accompanied by very high rates of credit growth, giving rise to a credit bubble. On other occasions, these build-ups sit simmering in the background, largely unnoticed until the proverbial s**t hits the fan, when they suddenly act as an amplifier causing a much steeper decline than would otherwise have been the case. I call these systemic vulnerabilities “slow burn Minsky moments.” Sadly, most markets appear to carry the fingerprints of these moments today.

Of course, the timing of when they will matter (when the collective scales will fall from investors’ eyes) is completely unknowable. So, what is an investor to do? Some will choose to follow Chuck Prince’s ill-fated advice from prior to the GFC and keep dancing as long as the music is playing. For the more cautiously inclined, tail risk insurance is a more likely option.

However, defining which risks you care about is, of course, vital. I’m assuming in this note that the risk is an equity market drawdown. In the past I’ve made the distinction between hedges (tightly correlated to the underlying event) and stores of value (strategies that pay off in the long term when the event occurs). The perfect insurance would exhibit both traits.

One of the easiest tail risk hedges in this case is to hold cash. However, many seem to suffer FOMO and thus cash is often shunned, although with cash rates rising perhaps this will be less of an issue. The other large group of tail risk insurance is perhaps best described as negatively correlated with the event. The most obvious is a long volatility strategy. However, whilst this is an excellent hedge, it has been a truly terrible store of value (which in turn erodes its ability to be a hedge when we are faced with timing uncertainty). Effectively, running a long volatility strategy is the investment equivalent of death by a thousand cuts.