If none of this ‘news’ came as a shock to you then welcome to the phenomenon of ‘risk habituation’. The more that people are exposed to a risk, the less risky that risk is perceived to be. When investors first heard each of those news items, there was a sharp market reaction. None of the problems have gone away, and in some cases (particularly the US) the risks have arguably increased.
Familiarity breeds contempt
One example is the different reaction to the debt ceiling in 2011 and to the fiscal cliff at the end of 2012. Uncertainty shot up in 2011 and so did volatility. Despite the fiscal cliff in 2012 being more risky than the debt ceiling in 2011, the Vix remained almost flat while policy uncertainty continued ever higher. This is risk habituation at work.
To be fair, there have been policy efforts by central banks and governments to try to fix some of the problems, and these may explain to some extent the more relaxed current attitude to risk. But these policy efforts have at best reduced the risks rather than eliminated them.
Intellectually, investors know that the efforts by politicians are as yet insufficient to fix the problems. However, they do not feel the fear that they previously felt when they thought about that fact. The more that people are exposed to a risk, the less risky that risk is perceived to be.
This risk habituation means that a number of headline risks that were significant a couple of years ago now cause markets less fear than
they used to (even though some problems have arguably worsened). There is a feedback mechanism at work between markets and politicians: the more optimistic markets are about the future, the less worried politicians seem to be about finding long-term solutions.
The paradox is that if markets become optimistic about the prospects for policy, they make that very outcome less likely because they remove the pressure on politicians.
But these policy efforts have at best reduced the risks rather than eliminated them. Intellectually, investors know that the efforts by politicians are as yet insufficient to fix the problems. However, they do not feel the fear they previously felt when they thought about that fact.
A paradoxical outlook
Thanks to risk habituation, equities started the year with a strong rally despite the fact that the US fiscal cliff deal resolved very little and there is the potential for a major upset from the debt ceiling. Paradoxically, the more positive the markets are about the future, the less worried politicians are about getting the right solution. After all, if the markets do not seem to be worried why should we be?
Unfortunately, when politicians become less worried they are less likely to come up with a solution. Do you remember the negotiations over the Troubled Asset Relief Program (TARP) in 2008: Congress said: “No”, which made the stock market collapse, which promptly
made Congress say: “Yes”.
The importance of policy for the economic outlook is higher than ever, which creates a paradox for markets. If markets become optimistic about the prospects for policy and stage a risk-on rally, they make that very outcome less likely because they remove the pressure on politicians.
Central banks also run the risk of removing pressure on politicians. This generates a repetitive risk-on/risk-off cycle and the underlying problems are only incrementally addressed. The only ways to break out of this loop are either for politicians to have the courage to do what is necessary without market pressure, or for markets to start ignoring the politicians.
Perhaps risk habituation makes that latter outcome more likely; in effect, markets could conquer fear by ignoring it.
