‘Tis a puzzlement…

No, we are not reminiscing about Yul Brynner’s indelible role in “The King and I”! Instead, we are wondering about the fact that the developed world seems to be experiencing ever more extreme behaviour by central banks in their quest to sustain, or re-start, economic demand and output, and to ward off the perceived perils of deflation. The result has been a downward spiral of nominal interest rates, until a number of central banks have found it necessary to move below the “Zero Bound” and into a negative policy rate regime.

As is, by now, well documented, this has led to some very strange outcomes in terms of risk versus reward, and to signs of the return of the good, old-fashioned competitive devaluation- truly a zero-sum game, and one fraught with danger for those who become collateral damage.

One can begin to hear the distant (or perhaps not-so-distant) sound of currency pegs failing. Certainly, many are coming under increasing strain, with potential unpleasant consequences for those caught on the wrong side of the carry trade, or FX cross- as happened recently re the Swiss Franc.

And here is a thought to ponder: deflation or ultra-low inflation was, with a few exceptions, the natural order of things for much of recorded economic history; yet, while nominal interest rates were often low, they did not dip into negative territory.

So, now we have an environment in which the ECB is embarking somewhat late on a programme of quantitative easing, with the aim of reigniting animal spirits in the Eurozone and returning inflation towards its 2% target. Unfortunately, inflation expectations, as recorded in market prices, remain in a steadily declining trend, and the stock of Eurozone government bonds with a maturity beyond one year that have a negative yield keeps rising, while economic demand remains generally sluggish, or even falling, notwithstanding some perhaps positive recent signals from some Eurozone countries, including Germany.

Couple this with still inflating and inflated asset prices; and the opportunity for dislocation and unexpected shocks continues to increase. In many ways, we are in uncharted territory in terms of monetary policy and its impact on the real world and people’s behaviour; and, even when intentions are “telegraphed” by central banks trying to manage expectations, past experience would tend to caution that markets will still be “surprised”, with potentially unfortunate consequences for emerging markets and non-US debtors borrowing in US dollars in particular.

As for rapid inflation, the risk of it occurring has a habit of being disregarded a potential problem, until it becomes one!

For Awbury, all we would say is that we are wary of all the conflicting signals “out there”; and that we are quite sure that there will be outcomes of the central bank actions that will be unpleasant and probably unintended. So, we maintain our vigilance; and continue to monitor a broad range of markets and indicators for signs that risks are moving from the realm of the predictable into that of the uncertain and dangerous.

– The Awbury Team

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Mean VaRiance…

It is a truism that past is not prologue; and that one should be careful not simply to project what happened (or did not happen) before as the basis of a decision or expectation about the future.

This fact was admirably demonstrated yet again recently when banks’ Value at Risk (VaR) models were shown to be inadequate, misleading and, therefore, dangerous in the wake of the Swiss National Bank’s decision to end the Swiss Franc’s peg to the Euro. Criticism of the VaR approach to risk management is not new. It was amply aired before and during the post-2007 financial crisis, when events that would supposedly not happen more than once in billions of years were a little too common! Therefore, it is a little disconcerting that banks (and their regulators) seem to continue to rely upon them to the extent that they do.

Those of us that have long experience and retain our memory of past events know that in the real world, extreme and unexpected events have a tendency to happen rather more frequently than quantitative and VaR-like models predict, because those models are usually rooted in observing the past over a relatively short period of time; and, thus, often do not record events or volatility that a sufficiently-long institutional memory would record and factor in.

Perhaps, risk managers, who by temperament are probably often Stoics (or should be!) might practice on a daily basis, one of the key (and most difficult) tenets of Stoicism- the premeditatio malorum, which involves imagining all the worst things that could occur in the immediate future and how one would deal with them? The idea is to develop resilience. Not surprisingly, this bears a remarkable resemblance to asking an individual what keeps them up at night in terms of events that could damage or destroy their business, franchise or ability to regulate or govern. There are developments of VaR, such as Tail VaR and Extreme Value Theory (EVT) that are intended to address standard VaR’s limitations, but the prevalence of the “once in 100 years” (i.e., 99.5% confidence level) approach as the basis for stress-testing and setting capital levels used in many financial regulatory regimes remains somewhat surprising; perhaps partly explicable because using more robust measures would require more capital and so reduce returns.

Naturally, we at Awbury are not saying that models such as VaR have no value or purpose, or that stress-testing models are invalid, but rather that their constraints and limitations need to be recognized and understood. Given our focus on E-CAT, providing our clients with ways to manage exposures to significant and complex financial and economic risks, we are careful both to identify and assess the impact of all the risks that could have a material adverse impact, and to try to think in ways that are not constrained by any particular worldview or intellectual framework, while avoiding indulging in scenarios that are simply not realistic. Of course, we also try to retain a healthy paranoia that we may not have foreseen a key risk; and so structure our transactions in ways that provide a balanced ratio of reward to risk, while addressing our clients’ key needs and concerns.

– The Awbury Team

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Decisions, decisions…! (Part 3)

In two previous posts, we discussed recent research from the respected Max Planck Institutes on how complex financial organizations make decisions in the face of uncertainty, focusing on so-called model uncertainty. In this third and final post on the topic, we shall focus on the second aspect of the research, strategic uncertainty- i.e., trying to address identifying who the other key players are in a market; what their actions may be; and how their decisions may affect outcomes.

Not surprisingly, the tenets of game theory feature in how decision-makers address this risk, but are sometimes honoured more in the breach rather than applied directly. One example is the apparent view of investment bankers that they can make other players predictable through direct action, rather than trying to guess their thinking and what an optimal outcome might be for all parties. Examples include testing pricing by placing orders, then swiftly cancelling them; or probing a client’s own strategy to see whether it conforms with previous experience or not. Perhaps this is an example of assuming that one always has superior knowledge or capabilities, an approach that can easily lead to ruin.

More usually, market participants try to develop a theory of the mind of others, relying upon intelligence-gathering and probing counterparts for potential weaknesses or vulnerabilities, and assessing their level of knowledge and sophistication. This seems more in line with game theory and an application of the poker-playing maxim that: “If you cannot find the sucker at the poker table, it’s probably you”. Clearly, understanding how others think is valuable, but it has to be tempered with avoiding becoming overly dependent upon an increasingly abstruse analysis of how others in turn think about you; how you might react to thinking about that; how the counterpart might think about you thinking about that…and so on. One can become trapped in the proverbial wilderness of mirrors by succumbing to such an approach, leading to terminal decision-paralysis. In reality, stopping at a relatively lower order of reasoning is likely to be much more functional and effective.

A third strand to coping with strategic uncertainty is considered to be communicating with others and thereby trying to influence them. In reality, none of us exists in isolation; and how and what we communicate is an essential part of achieving the most effective outcomes, even in the face of uncertainty. One question to bear in mind, however, as central banks recognize, is the extent to which one is merely providing information, or additionally trying to influence behaviour. We suspect that most financial market participants would aim for the latter.

And a final aspect to consider is whether one can actually change the rules of the game. One may be able literally to influence the behaviour and decisions of others; as well as reduce the level of uncertainty in a way favourable to the game-changer. Of course, such an attempt may be resisted for a variety of reasons; but it remains a valid, and acknowledged approach, although apparently not much studied.

In this, and the two previous posts on the topic, we have tried to give an overview of a complex and important area of research; where it seems to us there is more work to be done in order to understand better why financial market participants act and decide as they do. At Awbury, we believe that we need to absorb the knowledge generated by such studies in order to test and improve our own decision-making skills.

– The Awbury Team

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Beware the Greeks bearing gifts…

Of course, most observers would hardly consider the outcome of Greece’s recent parliamentary elections as a “gift” to the Eurozone, the “Troika” (IMF/ECB/European Commission), or anyone but other “insurgent” parties within Europe.

Already the phony war of rhetoric and manoeuvre has begun; and the commentariat is in full cry. At an estimated 175% of GDP, Greece’s sovereign obligations are at a level where they are well beyond the EU’s supposed 120% “sustainable” threshold, and are supported by an economy which is unbalanced and often still uncompetitive, with a banking system that, in effect, depends upon the “pleasure” of the ECB’s Council to continue to permit the Greek central bank to provide Emergency Liquidity Assistance (ELA) to function.

The now dominant Syriza party is an untested and unknown quantity in terms of how it is likely to behave in government, even though it has already made some “market friendly” gestures; and the extent to which it will be willing and able to negotiate with Greece’s creditors, both public/sovereign and private, on alleviating the state’s debt burden remains unclear in light of recent statements.

On the one hand, there are the private creditors, who very much want and expect to be repaid principal and interest in a timely manner, and not subjected to another “re-profiling”, “haircut”, or outright default. In reality, given that some 80% of Greek sovereign debt is owned by sovereign and public creditors, any decision on debt forgiveness or adjustment would be political in the true sense of the word; and the costs borne largely by taxpayers: one reason why the Germans in particular suffer such angst about how to handle the situation.

This leads to a very awkward dilemma: enforce the terms of existing Greek debt obligations- and run the risk of a Greek default and “Grexit”; or allow substantial debt relief- and risk not only encouraging such requests from other governments subject to “bailouts”, or their far-left and anti-capitalist opponents, but also the siren call of European nationalist and far-right parties, whose rising popularity is already disrupting electoral calculations across much of Europe.

In order to service and repay its obligations at par, Greece would have to run primary budget surpluses for the foreseeable future, and still run the risk of existing debt not being repaid in anyone’s lifetime! This would seem to be untenable on any realistic assessment. So, in our opinion, the most probable outcome is a re-opening of negotiations between Greece and its public creditors, because such a negotiation, if carried out rationally, is likely to result in a compromise that, while politically awkward, will nevertheless avoid the far more negative consequences of an outright refusal to negotiate; namely, a Greek default and exit from the Euro, and potentially the European Union. Such outcomes are almost certainly far worse than the alternatives. The rising turmoil within Greece’s surviving banks may well lead to a resolution being needed somewhat sooner than expected immediately after the elections.

At Awbury, we care about and carefully monitor such matters because their consequences need to be factored into our own assessments of probabilities and risks, when helping our clients manage their own complex and strategic economic and financial risks. Greece may be an “economic rounding error” on a European and global scale, but how events there play out in the coming weeks and months matter far beyond the Acropolis.

– The Awbury Team

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