The story of the Titanic shows that, despite their size, icebergs can be surprisingly difficult to assess. Although all may appear calm on the surface, danger may lurk beneath the waves. Spotting risks in the global economy can be just as tough, and our tools for finding potential hazards are even less evolved than those used at sea.
The health of economies is usually assessed using aggregate measures such as inflation and gross domestic product, but these are blunt tools at best. The inflation experience of the lowest and highest income brackets in a country can be very different, whereas aggregate measures of GDP can ignore the very important effect of demographics. Japan is an interesting case in point. Despite spending many years with inflation hovering around zero and with very low GDP growth by international standards, it has maintained high standards of living and low levels of unemployment, largely because per capita GDP has held up extremely well. In an aging world, per capita measures will have increasing importance. Adding to the confusion is uncertainty about how well traditional tools for evaluating economic activity are able to assess the virtual, online economy. There is also a growing sense of the need to reflect societal issues like income inequality in an overall assessment of economic health.
Assessing financial risk is no less problematic. Our methods rely heavily on quantitative analysis that largely revolves around the premise that price volatility is a perfect proxy for risk. Short-term price volatility may, however, be a poor proxy for other material risks such as credit, liquidity and bankruptcy. It does not accurately reflect the risk of a permanent loss of capital.
In the world of oceanography, researchers now use satellite images to try to spot icebergs from space. We in finance need to find a similar new perspective that gives us a broader view of risks. Effective risk management is a science and an art; it involves both mitigation and contingency planning. The fact that an event is predicted to occur only once in 200 years, for example, is irrelevant to the investor if this happens to be the year.
In many senses, in financial markets we are now navigating unchartered waters without the benefit of satellite images. Quantitative easing stopped the financial system from freezing over, but as the warm, balmy liquidity that quantitative easing has provided is withdrawn, who is to say where the icebergs will form? The Federal Reserve’s balance sheet has expanded to some $4 trillion, or roughly four times its average pre–financial crisis amount. Other central banks have played their part as well. There is no rule book for contracting a balance sheet of this size, to return it to what used to be considered normal. All anyone can say with certainty is that such a process is unlikely to be plain sailing.
One of the greatest faults of the financial services industry is our tendency to believe in our own invincibility. That can apply as much to our own business as to the assets that we manage on behalf of others. Despite high barriers to entry, including regulation, our industry is no less vulnerable to disruption than are others. Technology is opening up new distribution channels. Fintech is the industry buzzword du jour. The Titanic sank not just because it hit an iceberg but because its makers believed it was unsinkable. Our industry has shown signs of worryingly similar complacency.
Navigating the open seas or the financial markets will never be risk free. There are, however, things we can do to understand those risks, such as developing improved tools to manage them more efficiently and ensuring adequate contingency plans when those risks turn into a reality. That way, when the cry goes up to “Man the lifeboats,” we have a better chance of surviving choppy seas.
Anne Richards is global chief investment officer at Aberdeen Asset Management in Edinburgh.
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