Ever since the collapse of Lehman Brothers in 2008, investors have been acutely aware of tail risk—the unlikely possibility that an asset price will make a sharp, sudden move in value. The extreme risk that has characterized financial markets over the last three years, with its wild volatility, is the market’s way of grappling with improbable but potentially catastrophic events.
Mathematicians warn that calculating tail risk is especially prone to error, because traditional financial models underestimate the likelihood of extreme events occuring, or have bell-curve distributions of possible outcomes with what the quants call “fat tails” at what are supposed to be their thinnest ends. That is why the odds of catastrophe occurring are often higher than they might seem. As a result, the financial markets regularly underestimate the odds of a tail risk being realized—be it the collapse of the dot com bubble, the failure of the subprime debt market, or the bankruptcy of Lehman Brothers—until it is too late.
For investors, it’s critical to identify tail risks, understand their likelihood, and position themselves accordingly. A seemingly small error in calculating those risks can have a big impact on a portfolio. “If the odds of something happening are 10 percent, you don’t do anything about it. If the odds of something happening are 20 percent, you do,” says Jose Wynne, head of foreign exchange strategy at Barclays Capital in New York.
For now, markets are bracing for a tumultuous year, but they aren’t expecting the worst, at least when it comes to the crucial issue of the future of the euro zone. “Equities are pricing in a big risk event, but not of ‘Lehman’ magnitude,” Nomura equity strategist Ian Scott wrote in a report on December 9. As long as a Lehman-magnitude event is avoided, equities should “do well” in 2012, he argues. He says that even now, it is almost impossible to envisage a situation in which the European Central Bank (ECB) and the German government allow the breakup of the euro to proceed. His prediction: The ECB will ride to the rescue with a bond-buying program during the first quarter of 2012. Assuming that the euro zone crisis is brought under control, Scott forecasts the S&P 500 to rise about 15 percent by the end of next year, from a current 1221 to 1400.
Not everyone is quite so sanguine, though. Swiss asset manager Felix Zulauf told King World News that he expects the peripheral European nations to go into a depression, if they aren’t there already. Zulauf, who manages $1.7 billion, says Greece, with a 15 percent decline in GDP over the last three years, is there already. In his view, Greece and possibly Ireland and Portugal will exit the euro in 2012. If Zulauf, a member of the Barron’s Roundtable, is correct, the projections of Nomura and other investment banks easily could be upended.
In the United States, the main tail risk is the prospect of unexpectedly high interest rates. Already, there is speculation that the Federal Reserve will revise its plan to hold rates near zero until the middle of 2013, Bloomberg said, citing its own survey of economists. “The bond market will be very worried about the prospect of fiscal tightening in 2013,” Barclays Capital interest rate strategist Ajay Rajadhyaksh said. Rates could rise in the U.S. despite a slowdown in Europe and Asia, inflation hawks fear, because China and other buyers of Treasuries would diversify out of Treasuries, (lowering demand and pushing up yield). Also, the economy in the U.S. would continue to strengthen, building on the sort of momentum seen this morning with unemployment claims, which were below expectations. Rates are now at emergency levels—recession levels; the hawks say this can’t be justified if the economy is growing at 2 percent to 2.5 percent.
Perhaps the greatest tail risk facing the global market is the prospect of a hard landing in China. Among investors, there’s an almost universal presumption that that China’s growth will slow from the 10 percent range of last year to the 8 percent range next year, avoiding a recession, which in China means growth of less than about 6.5 percent. The theory is that China can have whatever growth it wants by using government spending to offset declines in the private sector.
However, the property bubble in China is deflating fast, leading to double digit declines in prices. If those declines lead to problems with credit and banks, even China could have a difficult time containing the situation.
“I haven’t spoken to anyone at all who doesn’t think this is a problem. The question is, how serious is it? The answers range from ‘it’s a problem and the downside is that some developers go out of business,’ to bears like hedge fund manager Jim Chanos, who forecast a complete meltdown,” says Phil Langham, senior portfolio manager for emerging markets at RBC Asset Management. Langham says he finds the soft landing scenario more credible, given the level of control China has exerted over its economy in the last few years.
What are the odds that all of these tail risks are fully understood and properly priced by the markets? Very low. “Tail risks are almost never fully priced into the market,” says Guy Stern, portfolio manager of the global absolute return strategy at Standard Life Investments. “That is their nature.”
