We Could Be Dangerously Close To A “Minsky Moment”

We Could Be Dangerously Close To A “Minsky Moment”
Stéphane Renevier, CFA

about 1 year ago6 mins

  • A Minsky moment is a tipping point in the financial markets when excessive debt accumulation becomes unsustainable. It occurs when borrowers can no longer meet their debt obligations using their income, leading to a sudden decline in asset prices and a financial crisis.

  • We may or may not be close to a Minsky moment now, but risks are high and conditions can evolve quickly, so you may want to prepare yourself in case it does happen.

  • Protect your portfolio by reviewing your investment process, and making sure your portfolio is diversified and defensive. And it can also be helpful to hold some cash.

A Minsky moment is a tipping point in the financial markets when excessive debt accumulation becomes unsustainable. It occurs when borrowers can no longer meet their debt obligations using their income, leading to a sudden decline in asset prices and a financial crisis.

We may or may not be close to a Minsky moment now, but risks are high and conditions can evolve quickly, so you may want to prepare yourself in case it does happen.

Protect your portfolio by reviewing your investment process, and making sure your portfolio is diversified and defensive. And it can also be helpful to hold some cash.

It’s a risk no one wants to think about, and it could be rising. It’s what’s known as a “Minsky moment”, a sudden and severe market correction that follows years of market excesses and debt buildup. It’s a dreaded bust after years of boom, and it tends to have wide-reaching consequences for people and the economy. Here’s what you need to know about these moments and what you can do now to protect your portfolio…

How does this kind of thing happen?

I can sum this up in just three words: stability fosters instability.

See, economist Hyman Minsky argued that extended periods of macroeconomic stability and prosperity actually create the conditions that lead to financial instability and crises. That’s because long stable periods lead investors and institutions to become overconfident and complacent. They take on more risk, accumulate more debt, and start to forget about past crises. That in turn boosts asset prices and lowers volatility, creating the illusion of a new era of market stability. The issue is, it’s not sustainable.

According to Minsky’s theory, there are three stages of financing that can lead to instability: hedge finance, speculative finance, and Ponzi finance.

In the hedge finance stage, borrowers (both companies and individuals) are able to repay the principal and the interest on their debts from their cash flows. This is healthy and promotes economic growth, since borrowing can help finance projects. But as the economy grows and investors become more confident, they start to move toward riskier types of borrowing.

That leads us to the speculative finance stage, where borrowers are able to repay only the interest on their debt and are forced to roll over the principal. This creates a situation where borrowers become increasingly reliant on increasing asset prices in order to be able to repay their debts, leading to a buildup of speculation. The system at this point is more unstable, as a shock could lead borrowers to default on their debt.

Finally, in the Ponzi finance stage, borrowers can't repay even the interest on their debt from their cash flows, and have to borrow even more money to service their existing debt. This creates a situation where the entire financial system is dependent on a continuous flow of new borrowing to sustain itself. At this stage, the financial system becomes extremely fragile, as any shock – like a rise in interest rates – could lead to an unraveling of the credit system.

But these stages all are fleeting, and markets inevitably reach the “Minsky moment”, which occurs when borrowers can no longer meet their debt obligations, leading to both a sudden collapse in asset prices and a financial crisis. This phase is accompanied by a painful deleveraging period, where debts are monetized or restructured. And once that all happens, the cycle can start all over again.

The three stages of financing and Minsky moment. Source: Twitter
The three stages of financing and Minsky moment. Source: Twitter

Are we close to a Minsky moment now?

It’s a tough one to call, but many of the factors are certainly present. A prolonged period of exceptional macroeconomic stability (falling interest rates, stable growth and inflation, globalization, fewer global conflicts) has created excesses in markets and parts of the economy. Global debt levels have reached very elevated levels. The Ponzi finance scenario of borrowing more money to finance earlier borrowing has arguably permeated at least some markets. And after central banks raised interest rates at their most aggressive pace ever, we’ve witnessed more than one isolated “financial accident”, suggesting the system may be struggling to cope with higher interest rates. From here, we could see a very slippery slope – a broader increase in defaults, contagion, and credit contraction.

Now this doesn’t mean we’re definitely going to see the mother of all crashes. Our financial system probably is better equipped to deal with another credit crisis (although perhaps not as well as most hope), and there seem to be fewer excesses out there. Should the Fed manage to achieve a softish-landing (that is, bringing down inflation without sparking a deep recession) – or even a hard-landing without a full-blown financial crisis – we could well see another leg up in the credit cycle and the Minsky moment could be delayed for some other time. But it’s important to remember that with the interconnected nature of markets (and market sentiment) and the economy, things can deteriorate quickly and a crisis can develop much faster than you might think.

As I’ve said so many times before: with a financial crisis, you can never know what’s going to trigger them, when they’re going to happen, or how bad they might get.

OK, so what can you take from all this?

First, try to accept that crisis and financial instability are part of the financial system, and are inevitable. Since you’ll almost certainly have to face a crisis at some point in your investing life, you might want to make sure that your strategy can handle it. After all, crises bring the best opportunities.

If you want to protect your portfolio, the first – and most important – thing to do is review your investment process. Make sure you’ve clearly defined it before a crisis hits. Ask yourself these questions (I wrote more on this process here):

  • Will you really be able to stay the course if markets are down, say, 60% – and avoid pulling the plug at the worst possible time?
  • What will you sell first if needed: your losers or your winners?
  • How will you decide when to sell your positions, and when to start buying again?
  • How could you use stop-losses or hedges to protect against downside moves?
  • How will you make sure you won’t make emotional decisions?

As for your portfolio, make sure it’s diversified. Choose stocks from across styles (not just growth stocks, but also value and quality ones), regions (not just US, but also global), and sectors (not just cyclical ones, but also defensive ones like healthcare or consumer staples). Consider owning some Treasury bonds (to protect against a depression), gold (to protect against stagflation), and US dollars (to protect against a collapse in liquidity). The mix of assets could also help make your portfolio more robust (although there’s no guarantee that it’ll always work).

More advanced investors might also want to look at implementing a “1x2 put ratio” on a stock or high-yield credit index ETF – where you sell a slightly out-of-the-money put option, and buys twice the amount of further out-of-the-money put options. As I explained here, you’d lose money in the case of a small correction but you could make significant returns in the case of a larger fall (and you’d lose nothing if markets continue to rise).

Right now, the best strategy of all might be to hold some cash. It’ll allow you to preserve not only your financial capital, but also your psychological capital, making you more likely to pounce on opportunities when they present themselves. And, with cash currently yielding more than it has in a long time, you’ll be paid handsomely for the benefit.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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