A big drop in stock markets around the world could only require a “small trigger,” Citi bank has warned.
The FTSE 100 has been breaking records recently, with stock markets elsewhere in the world also riding high. But Citi thinks thinks the situation looks precarious.
In a note circulated on Monday, the bank argues that investors around the world are getting complacent and, as a result, global markets face a bigger risk from “unexpected outcomes to expected events” than they do from hard-to-predict or unexpected events, known as “black swans.”
Citi says: “These outcomes [unexpected outcomes to expected events] catch market participants by surprise because of an embedded bias.”
Britain’s vote to leave the EU would be one example of an “unexpected outcome to expected events” — markets were almost certain that the UK would vote to remain and the market shock was all the greater when the result was announced.
Everyone is putting money in the same place because they are certain that things will go one way. If something unexpected happens — the Brexit vote or perhaps a Trump victory in the US — then there could be huge lurches in global markets are everyone rushes to reverse or unwind the same trades.
Why are markets so one-sided? Citi argues it’s because there is actually a greater level of certainty in global markets than there has been for a long time, which also explains why market volatility is falling. The memo reads:
“Is the current environment really more uncertain than during the economic booms and busts of previous bubbles and cycles? Is the geo-political outlook really more uncertain than it was in the 1960s and 70s? Is the outlook for Europe more uncertain than it was during the lead-up to European Monetary Union? It is not. In many ways, it is more certain.”
It’s this certainty that proves risky for investors, however, because “a perception of higher certainty creates consensus, consensus creates complacency, and complacency creates risk.”
Citi adds that the trigger for a market slump doesn’t have to be as seismic as Brexit or a Trump victory. The bank says: “We would caution that recent price action suggests that confidence might be waning. A big reversal will still require a trigger, but it might only need to be a small trigger.”
“Beware of unexpected outcomes to expected events,” the memo warns.