RBA Assistant Governor Guy Debelle was speaking at Citibank’s Australia and New Zealand investment conference this morning on volatility – or lack thereof – in markets.
In what is a must read speech Debelle summed up why stocks are suddenly under such intense pressure perfectly:
The relative stability of macroeconomic outcomes might be delivering a little more stability in the numerator in investors’ calculation of expected future returns. But it is not clear to me why there should be more stability in the denominator, the discount rate. If anything I would argue the converse, namely there is at least as much uncertainty about the future path of interest rates as in earlier periods.
That might sound a bit wonkish but, it is spot on in saying that the uncertainty about the discount rate used to turn “expected future returns” into a net present value is a key part of the valuation process.
But when you add uncertainties about earnings going forward, world growth and even Ebola in the west, you also get instability in the numerator of this equation. That is why stocks are in a little funk and volatility is rising from record lows.
The equation traders and investors use to work out value is broken. And all traders know that if you put garbage in you get garbage out so as uncertainty rises they move to the sidelines awaiting clarity.
But as Debelle highlights volatility is still low and scarily he makes a point for more, not less, volatility ahead. “One thing which is certain is that the low volatility will not persist. What will cause it to end? I really don’t know,” he said.
No one else does either, that’s the point.
So while Debelle is not saying there is a crash ahead he is sounding a warning that some investments will “blow up”. Which ones? We’ll only know in hindsight.
You can read Debelle’s speech here