lunes, 4 de enero de 2016

lunes, enero 04, 2016

The surprise factor for investors in 2016

 
 
 
Imagine the ramifications of a revolution in Saudi Arabia, the world’s largest producer of oil.
 
Would the price of crude stop rising beyond $100 per barrel? Or how about a combination of events which trigger alarm in the €2.1tn Italian sovereign bond market: say, the collapse of Matteo Renzi’s administration while 600,000 people are evacuated from the shadow of a rumbling Vesuvius.
 
No matter how unlikely such scenarios may seem, for professional investors it is essential to play a version of this what-if game as they decide where to allocate their money in 2016. There may be opportunity but do not forget to assess the risks.

Some are quotidian: will a company struggle to generate cash flow, or will a particular asset — forestry land, retail stocks, impressionist art — fall into or out of vogue.

Others are known as “tail-risks”, outcomes existing in the narrow, far reaches of statistical probability distributions.

Popularised by critiques of the flawed models at banks and rating agencies, which featured prominently during the financial crisis of 2008, the term has become part of the daily jargon of investing.

Tail risk describes those type of shocks that might occur but are not generally expected. As such, should they occur, a hefty blow to investments is usually the end result.

For instance — as examined in the FT’s recent series on the shocks of 2015 — there were a selection of surprises which inflicted portfolio damage last year.
 
From the Swiss National Bank dropping its currency peg to the euro in January, to the closing of a prominent mutual fund by credit specialist Third Avenue in December, investors had regular reminders of the way a promising investment strategy can be ruined by an unexpected event.
 
So, collected from investors and strategists in recent weeks we present a selection of possible but not probable tail risks — good and bad — to watch out for in the coming year.

China: the slowdown isn’t gente

Michael Hasenstab, chief investment officer for Templeton Global Macro says “our call is that China will not have a hard landing . . . If for any reason we were to see that not occur, that would be a game changer. The China call is the most critical call any investor has to make.”

Tail risks chart
 
The debt investor, who has a reputation for making big calls on risky countries such as Ireland or the Ukraine, is right to highlight the state of the Chinese economy.
 
One of the big surprises of 2015 was a decision by the authorities to let the value of the renminbi fall in August, prompting a month of market turmoil around the world which led the Federal Reserve to delay raising interest rates.
 
The chief concern then and now is the pace at which the Chinese economy slows. After a decade during which demand for commodities boosted emerging market economies around the world, a slowdown in buying has spurred a collapse in prices for raw materials and widespread pain for their producers.
 
This shift comes as the Chinese authorities attempt to manage a transition in the economy away from investment in building and infrastructure towards greater internal consumption of goods and services.
 
Get the mix of reform and economic stimulus wrong, however, and a crash would reverberate worldwide.

Or the currency collapses

The two scenarios are not mutually exclusive but David Lubin, head of emerging market economics at Citi, says investors should keep a close eye on capital outflows from China.

The People’s Bank of China’s foreign exchange reserves have fallen from nearly $4tn in June 2014 to about $3.4tn today as it intervened in markets to defend the value of the currency, which has been allowed to weaken only moderately.
 
Such a large pile of reserves still leaves policymakers with options, but some analysts question the true value of those reserves, as spending them can create negative momentum for a currency when the need to act highlights underlying fragility.

“At some stage, reserves may fall to a threshold level where market participants begin to question whether China’s policy flexibility is really as strong as they previously thought,” says Mr Lubin. “That is not a good outcome for emerging markets.”

Inflation returns
 
Big drops in the value of emerging market currencies, particularly the Chinese renminbi, may help suppress price inflation in the US and the developing world by lowering the price of imported goods.
 
Tail risks chart

Yet several investors highlight the risk that inflation starts picking up after seven years of central bank action to prevent economies slipping into deflation and depression.

The Federal Reserve announced in December that interest rates will rise at a “gradual” pace in the coming years, but a rapid pick-up in the economy could upend assumptions about bond prices, which fall as interest rates rise.
 
Iain Stealey, portfolio manager for JPMorgan Asset Management, says: “As a fixed income investor the biggest tail risk we have is that the low growth, low inflation environment is just wrong and growth, wage inflation picks up. The Fed is completely behind the curve, that’s the risk we worry about.”

It may not even require stronger economic growth to get a surprise. The US unemployment rate has fallen from more than 10 per cent to just 5 per cent, meaning it has become harder to hire and retain staff.

When unemployment was the big issue, it was common to hear prominent investors and economists warn about the risks of inflation posed by central bank programmes of bond buying. After six years of waiting the inflationists have been relegated to the fringe.

Paul Lambert, of Insight Investment, says: “Wage inflation in the US could lead to a much sharper rate cycle in the US despite still relatively modest growth that will fuel a significant rise in currency market and asset market volatility. It’s like the wolf that might finally arrive just as everyone stopped believing the little boy.”

Alternatively, a risk is that it is investors, not the Fed, who are behind the curve. Market prices imply the US central bank will announce two quarter-point interest rate increases next year.
 
The policymakers, however, on average forecast four, and a robust economy could compel larger or more frequent rate rises.
 
Discounting the Fed’s more hawkish forecasts has been a good strategy so far, and many investors still predict little momentum in long-term interest rates. But “we’re approaching an inflection point”, argues Alex Roever, head of US interest rate strategy at JPMorgan. “We’re going to see some stresses as the tide goes out.”
.
The dollar drops and raw materials rebound
To say investors are disillusioned with commodities is an understatement. As an asset class raw materials have promised much and delivered little over the past decade, except for disappointment.

Tail risks chart
 
 
The Bloomberg Commodity Index, a broad-based index of 22 raw materials widely followed by investors, for example, has fallen to its lowest level since the financial crisis and chalked up five consecutive years of losses since 2011.
 
Yet while few predict a return to boom time prices, it is possible to identify some low-probability events that would improve sentiment, aside from the obvious impact a pick-up in Chinese economic growth would have, or were Beijing to launch a giant stimulus programme to that end.

One is a large scale US dollar devaluation, as a strengthening greenback has been one of the biggest headwinds facing commodity markets in 2015. As resources are priced in dollars, raw materials have become more expensive for non-US buyers. A weaker dollar would thus represent a welcome price cut.
 
“Currencies are notoriously hard to forecast, and it would not be the first time they have wrongfooted consensus,” says Colin Hamilton, head of commodities research at Macquarie. “The difficulty is in seeing what would cause such a shift.”

The other, perhaps more unlikely event which could scare the commodity bears would be co-ordinated crude oil output cuts by large producers in and outside Opec, the cartel which attempts to manage production.

Not only would an agreement to pump less put a floor under the price of crude, it could trigger a so-called short squeeze as hedge funds and speculators scramble to close record bets that the price has further to fall.

A rising oil price could also help attract money back into commodities, says Mr Hamilton. One of the reasons for the poor performance of the sector over the past year has been the heavy selling of investment products that were heavily weighted towards oil but also contained exposure to metals and grains — markets that struggle to cope with large redemptions.

Normal is not nice and quiet

Investors have become used to a world dominated by central banks. These institutions pushed down the cost of government borrowing with giant programmes of bond buying, which in turn bolstered the price of assets such as equities and property. Money has flowed to wherever it could find a bit of extra income.

Now the Fed has begun to raise rates, what will the world be like without constant central bank support?

Mohamed El-Erian, chief economic adviser at Allianz, says that, if the Fed and other central banks do succeed in returning the world to ‘normality’, there may be unintended consequences.

“We are coming out of a period in which central banks have successfully suppressed natural market volatility,” he says. “A lot of capital flowed into the emerging world [under the Fed’s quantitative easing programme] and it is going to continue to look to get out as volatility rises.

In some cases it will contribute to [conditions on] those markets that have become unhinged.”

Remember Europe
 
 
Surprises don’t have to be unpleasant. Ewen Cameron-Watt, BlackRock chief investment strategist, has the eurozone in mind, where a nascent recovery will get a boost from an expansion in government spending, part of it related to the influx of refugees.
 
 
Tail risks chart


“We can always pick an improbable surprise. I think it’s more interesting to pick something plausible, such as European performance and a US growth undershoot. A surprise would be if in the second half of 2016 European economic growth accelerates beyond US growth.”

Such a result might produce a year of earnings growth for European listed companies, something which has failed to arrive since 2010, regularly foiling the predictions of strategists and analysts.

Holders of government debt might be less happy, however. An end-of-year surprise was the decision by the European Central Bank not to increase the size of its monthly bond purchases in December, after what had appeared to be strong hints to the contrary ahead of the announcement.
 
Stronger growth would challenge assumptions that very low interest rates have become normal.


But beware “Brexit”
 
The UK’s Conservative government has promised a referendum on membership of the European Union to satisfy a large section of its party dissatisfied with the constitutional and commercial postwar settlement.
 
The risk is a victory for the “outs”, after which there would be a long list of open questions about the practical, legal and constitutional implications.

For instance, Europe employs the Continent’s expert trade negotiators, so who will negotiate the UK’s new position with the world? What will multinational banks do with European headquarters no longer based inside Europe? Can Scotland stay in if the rest of the UK leaves?

As Willem Buiter, Citi chief economist, puts it: “If it goes wrong the British economy would vanish for the next 10 years. Because it would create uncertainty about the EU unravelling, it’s big enough to matter for the global economy.”


Additional reporting by Miles Johnson and David Oakley

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