So, which particular EU tail risk do you prefer…?
In the current environment in which all sorts of “truths, half-truths and untruths” are being promulgated, and rhetoric can become very intemperate and irrational, it is usually worth pausing for a moment to re-examine whether or not the risks that one is supposed to worry about (Brexit, Russian irredentism, North Korea, the Great Wall of the Rio Grande) are the ones that matter.
Therefore, even though “markets” are often wrong in terms of signaling risks or outcomes, it is worth paying attention to factors that may seem obscure, but indicate that all may not be well. So far as the EU is concerned, there are a number of topics to cause concern about “tail risks”:
– Greece continues to struggle with austerity and “compliance” with the measures imposed on it by the “troika”, which increases the probability of another “Grexit” crisis
– With the candidacies of the so-called “mainstream” parties of the left and right in turmoil, the odds of a victory in the Second Round of the Presidential elections due in early May for the far-right nationalist Marine Le Pen have begun shortening
– Italy is “too quiet”, yet nothing has actually been solved, in terms of political and constitutional arrangements, nor in addressing the sclerotic banking system, choking on its non-performing loans
And the whole point about “tail risks” is that they have a tendency to be somewhat more probable and extreme than any model can forecast, no matter how many Monte Carlo iterations are performed! Yet, currently, bond yields, spreads and volatility remain remarkably low, as if everything will ultimately sort itself out through the usual “Euro-fudge”.
We would not be so sanguine. As recent events in the UK and the US have shown, it is becoming rather dangerous to assume that the old, post-WW II neo-liberal Western consensus still holds. There is too much metaphorical and literal bomb-throwing going on in too many places, both within and outside the EU, for anyone to be able to comfort themselves that all will be well.
So, it is telling that what many would regard as a really obscure indicator, the differential between so-called CDS-2014 and CDS-2003 contracts (i.e., contracts that include a payout based currency redenomination risk and those that do not) has recently doubled from 20 to 40 basis points in respect of Italy; and from 3 to 24 basis points in respect of France, as pointed out by Marcello Minenna of Consob, the Italian securities market regulator. Now, we admit that this is truly arcane; but the message it conveys is that there are those in the markets who are concerned that the risk of certain countries deciding to or being forced to exit the Euro is rising, especially when Le Pen has made it clear that she favours “Frexit”, while a majority of Italians believe that the Euro is a “bad thing” for the country.
Perhaps the broader point to be made is that human beings, while they can contemplate the possibility of extreme events occurring, find it very difficult to believe that they actually will. And yet history is sadly littered with the bodies of those who could not accept that they would be the victims of a bad outcome.
Of course, we would not characterize the likely consequences of Grexit, Frexit, or Italexit as humanitarian disasters (although the Greeks might argue that they have already experienced that within the EU/Eurozone), but any one of them would increase the risk of existential turmoil within Europe, and its vulnerability to predation.
At Awbury, we try to make a habit of always asking the “but what if…?” questions, because we wish to avoid the risk of being prey! We would suggest that there are secular changes under way that bear close observation and analysis.
To be continued…
The Awbury Team