Financial success for international professionals

Can we dodge the Black Swan bullet?

· by Roy Walker · Read in about 9 min · (1712 Words)

Why the likelihood of another financial crisis is rising.

Lehmans Swan

Economic possibilities fall into two realms. The first is scalar. This is the arena that usually occupies institutional economists and ‘talking heads’ on Bloomberg. Will US growth be 1.6 percent or 1.8 percent next year? Will the bank of England reduce rates to zero or keep them at 0.25 percent?

The second realm is binary. On, off. War, no war. Crisis, no crisis. This is the arena that typically gets less attention, because although the downside impact can be great, the probability is often quite small. If we take on board Nassim Nicholas Taleb’s concept of a ‘Black Swan’ (a random and unpredicted event that deviates outside what is normally expected, e.g. the roots of the 2008/09 financial crisis) then it’s easy to understand why truly unexpected events don’t get press inches or Bloomberg airtime, because they’re… well, unexpected. It’s left to wacko pessimists, doomsday scenario authors, and non-mainstream economists to raise these spectres (I count myself in the first group).

If we want to get a handle on the cataclysmic downside, there are two measures we need to be concerned about. The first is

(i) the probability of such a shock event happening, and the second is

(ii) the ability of the global economy to withstand it.

If we had this information, it would be extraordinarily useful when planning our investment portfolios. But of course, these measures are vague, subjective, undefined. So when the IMF makes forecasts that global growth will ‘slow to 3.1 percent this year before recovering to 3.4 percent next year’, those numbers necessarily ignore the likelihood of the wheels falling completely off the cart of the global economy.

Pay attention to the words - not just the numbers

This is why when the Federal Reserve, the IMF, the World Bank, the OECD, etc., make economic announcements, we should pay attention to the commentary as much as the numbers, because the commentary gives insight to the subjective binary likelihoods, not just the scalar forecasts (which are subjective also, but our frailty is to put too much faith in numbers - especially when quoted to multiple decimal places).

A few weeks ago, French bank Societe Generale issued a report placing their estimation on likelihood of specific ‘Black Swan events’ happening, as follows:

  1. Double-drag from European policy uncertainty: 40%
  2. China hard landing: 30%
  3. Sharp re-pricing of Fed expectations: 25%
  4. Sharply weaker global growth: 20%

If these events are assumed independent, then a simple probability calculation shows that the likelihood of at least one happening is:

Chance of at least one event occurring = 1 - (0.6 x 0.7 x 0.75 x 0.8) = 74.8%

A 75 percent chance of one of these events occurring is scary. Having said that, even if we agreed with the probabilities as stated, almost by definition they are not strictly Black Swan events, because they already exist as known possible events. Moreover, the impact on the global economy is different for each, with varying degrees of severity. But they do count as ‘shock’ or potentially crisis inducing events.

So it’s worth bearing in mind the calculation:

Prob(At least one of a set of independent events happens) = 1 - Prob(none of the events happen)

e.g. P(A or B or C) = 1 - [ (1-P(A)) x (1-P(B)) x (1-P(B)) ] etc.

So for example, if there are five possible independent events that each has a 5% chance of occurring, then the chance of at least one of them happening is:

Chance of a crisis event = 1 - (0.95)^5 = 22%

If there are ten possible shock events (each with 5% likelihood), then

the chance of at least one occurring = 1 - (0.95)^10 = 40%.

Ok, ‘Be realistic,’ I hear you say, ‘those ten events have only 2% probability each!’

In that case, the figure is: 1 - (0.98)^10 = 18%. i.e. almost 1 in 5. (And at 1% probability each, there’s still an overall 1 in 10 chance of at least one occurring.)

Of course, we’re just playing with numbers, but it underlines why we need to pay attention to those commentaries from Janet Yellen, Mark Carney, Mario Draghi, Christine Lagarde, etc. Although in isolation a snippet of warning may seem insignificant, their importance adds up in reality as well as mathematically. Also, remember, these folks are guiding the global economy and it’s part of their job description to calm our nerves. It seems eminently possible that concerns will be downplayed when publicly voiced.

But not everyone minces words. In the same week as the referenced SocGen report, the G7 leaders were in Japan being addressed by Shinzo Abe, prime minister of the world’s third largest economy. He spoke of a Lehman-style crisis looming:

The G7 must not turn their eyes away from the risks. If the policy response is wrong, leaders must be aware that there is a risk the world economy will fall into a crisis beyond the usual economic cycle. (as quoted)

Mr Abe referred to the extraordinary rise in global debt over recent years. According to the Economist Intelligence Unit, global government debt was about USD $30 trillion in 2005. In 2016 it will hit USD $60 trillion. A precipitous rise, but this figure excludes the possibly more important corporate and private debt, as illustrated by the (slightly dated) infographic below.

Global debt increase

Source: Statista / Forbes / McKinsey Global Institute

I won’t make a list of all the economic danger zones in this article, but overall global debt is almost certainly the most important one, because it relates directly to the world economy’s ability to withstand a financial shock. The LA Times reports that in 2014 more than 5,200 emerging markets companies together borrowed US $1.1 trillion via bond issuances - double the borrowing of 2010.

Emerging market bond issuances

Source: Dealogic / LATimes

As debt rises, the potential for bad loans rises. When potential becomes actual, loans are not repaid as businesses fail. Banks and creditors are exposed and may fail themselves or need bailing out. The economy unravels. This is what Shinzo Abe was expressing concern about, but the closing communique of that G7 meeting was watered down. It seems to me the other G7 leaders were more focused on the likelihood of individual events happening, rather than the global economy’s ability to counter a shock if one did.

I started writing this article yesterday, and by genuine sheer coincidence this morning I see that overnight the IMF has released its October 2016 Fiscal Monitor. The theme of the entire narrative is - wait for it, … the threat of global debt and what governments can do to mitigate that threat, particularly in respect of deleveraging (reducing debt leveraging). There is also insightful discussion of the extent of the global private debt overhang (when a borrower’s debt service exceeds its future repayment capacity) and why this is significant.

Figure: Gross Global Debt - Percent of GDP, weighted average

Gross global debt as percent of GDP

Source: various, via IMF graphic

The report is a useful and important document. Here are some highlights quoted directly from the text (my emphasis):

  • “At 225 percent of world GDP, the global debt of the nonfinancial sector - comprising the general government, households, and nonfinancial firms - is currently at an all-time high. Two-thirds, amounting to about $100 trillion, consists of liabilities of the private sector which, as documented in an extensive literature, can carry great risks when they reach excessive levels.”

  • “There are concerns that the sheer size of debt could set the stage for an unprecedented private deleveraging process that could thwart the fragile economic recovery.”

  • “Private debt is high not only among advanced economies, but also in a few systemically important emerging market economies. High private debt not only increases the likelihood of a financial crisis but can also hamper growth even in its absence, as highly indebted borrowers eventually decrease their consumption and investment.”

  • “High public debt is not without its risks… The reason is that the absence of fiscal buffers prior to the crisis significantly curtails the ability to conduct countercyclical fiscal policy.”

  • “The resolution of the debt problem in an era of low nominal growth is likely to require growth-friendly fiscal policies… These policies are important for those advanced economies, particularly in the euro area, in which the slow progress in addressing banks’ remaining weaknesses is currently impinging on growth. It is also a priority in emerging market economies, notably China, in which the corporate debt overhang is creating vulnerabilities in the banking sector, increasing the risk of a disorderly deleveraging.”

  • “At $152 trillion, global debt is at an all-time high, but not all countries are in the same phase of the debt cycle, nor do they face the same risks. In a few systemically important emerging market economies, private credit has expanded briskly in recent years. The speed of the increase dangerously resembles that in advanced economies in the run-up to the global financial crisis.

The IMF is effectively saying “Guys, Shinzo was right, we need to pay attention to this, now.”

So, if massive global debt represents the calibre of the bullet, let’s briefly revisit the likelihood of the trigger being pulled. What other sources can we find regarding the chance of a global financial crisis? Well, we can ask a bunch of smart people perhaps:

In this article Ron Rimkus reports on a poll of readers of the CFA Institute Financial NewsBrief. The CFA Institute is a worldwide beacon of financial smartness, so we are fairly safe to assume that the readership represents a good collection of thoughtful opinion. Here are the results:

Chances of a gloabl crisis

We can read the chart as follows:

  • 44 percent of respondents thought there was a 25 percent chance of a global financial crisis in the next five years;
  • 23 percent of respondents thought there was a 50 percent chance of a crisis within five years;
  • 7 percent of respondents though there was a 100 percent chance of a crisis within five years;
  • Only 13 percent of respondents thought there was no chance of global financial crisis within five years.

Note that this survey was reported in June 2015.
We might ask ourselves, are things less precarious today, or more?

And everyone thinks I dodged a bullet, but I think I shot the gun.