Is the world riskier?

Here is a question received from a client recently. 

It’s a question that many people have been asking themselves, in one form or another over the past couple of years, so we are going to take a bit of extra time to address just what is happening with volatility and investment currently. As an interesting aside, i started this note in January 2011… and it is still as relevant today!

So, is the world riskier post the Global Financial Crisis?:

YES – but not always in ways that are obvious.

Current Volatility

There are various ways of looking at risk. One of those is volatility. It’s not the best measure of risk, as higher volatility can simply reflect greater uncertainty of predicting future incomes. Therefore, volatility should be used carefully when considered as a measure of risk. In other words, the value of your home will change every single day – it’s just that you don’t see that change because buying and selling houses is a closed shop. There is no transparency and the market does not provide regular feedback on its specific value. However, that doesn’t really stop you from appreciating that the house does have a rough value. The fact that the price likely to be obtained in a given period will reflect the economic and specific house conditions over time isn’t really going to be used by you as a decision benchmark on buying or selling on a given day.

The current volatility has many causes. Here are just a few:

• Global Banking instability – the global financial crisis of 2008 was really a banking crisis. This one was bigger than a lot of previous banking busts, and the scale of money destroyed was measured in the trillions of dollars. This would usually have resulted in an extended period of consolidation as those individuals and institutions holding the least stable debt fell into bankruptcy. However, the transfer of debt from private institutions to countries has simply transferred the risk from corporate to sovereign and at the same time hidden and amplified the problems.
• Political instability – Governments around the world are proving ineffective in combatting the perceptions of weakness. The European Union leaders dithering over who should pay for what, and who should or should not be allowed to go broke simply fuels expectations that conditions are worse than they are – and that they will not get better. Japan has enjoyed 6 prime ministers in 5 years and the US has a Senate that cannot effectively pass legislation. The German government faces elections and needs minorities to support any of its ideas, while Italy has its own political farce. All-in-all, the economic crisis has created political uncertainty or political uncertainty is fostering the economic crisis. For investors, it’s the same thing.
• Printing money – different terms are used for the same thing here… When governments run out of money they do not need to go to the bank for more. They can simply print more money – doing this or that to make more money available, at cheaper rates. The idea is that this wave of cheap money will encourage people to take risks, to build productive enterprises and to employ people to do so. The US has recently announced that $400bn or so of its $2trillion+ debt portfolio will be moved to longer dated securities. This logically reduces long term rates, and the idea is that this will make people more comfortable to make long term decisions. Hah! Excuse me while i laugh a jolly laugh at that one. Anyway, printing money eventually has to stop or you create a worthless currency. When you have to start reducing the amount of money out there you will either need a booming market or tighter budgets to make things work – neither looks all that workable at the moment, so the cycle of printing money does not have an obvious end.
• Booms and bubbles – This is where things are not so obvious. When money is cheap and easy to get then it is easy to be less attentive to using it effectively. This causes booms and bubbles but in areas where they are least expected or understood. The Chinese pegging of their currency to the US dollar is an obvious bubble – all arguments for long term stability etc, etc, etc to the side. Gold has enjoyed massive increases in price with many experts calmly announcing likely 20% or 50% increases still to come. 10 year US interest rates below 1.8%pa are a bubble. All bubbles eventually deflate – it’s just that we all have to hope they deflate instead of popping.
• Technology and the magical guru – I am not being as cynical nor as flippant as the words suggest here but there is a large pool of thought that technology will continue to work wonders, and clever people will come up with new and better ways to make less with more for longer and cheaper. The social issues connected with these trends are argued away with the annoyed wave of a hand. However, structural change does not come easily, and long term trends are not always obvious. Technology is very fast moving in todays world, and the outcome of technological changes cannot be predicted. They may be beneficial but there is no certainty that they will be profitable or productive. Facebook and Google are advertising companies that are valued at tens of billions or hundreds of billions of dollars but they employ very few people and the wealth they have created tends to be in only a small number of hands.

What does this volatility mean to us individually? There is no doubt that it causes a lot of discomfort. Each of us will have overall finances that will make large changes in prices more or less of an issue. There is also our individual ability to cope emotionally with these changes.

It is “standard” at this point in any post-crash environment for people to capitulate and decide that the world will never get better – that returns will never go back to the long term averages and that the basic fabric of the world of money has changed forever. This particular financial crisis could turn out to be different and it could cascade into another Great Depression. However, the risks of that happening are small. They are not insignificant but they are not the most likely outcome. Planning for a Great Depression is very different to planning for another 1987 or ’70’s crash and recovery period. Which recession is this one most likely going to reflect when we look back in 10 years time?

We will look at past recessions another day, and look at the broader return points for the last few decades. You will probably be surprised at what decade-long analysis uncovers.

So is the world riskier?

However, when considering “riskier” we also need to look at timeframes and expectations. Out of the range of possible outcomes for the medium term we have anything from booming markets to a deflationary price spiral. If we were to allocate possibilities to each outcome then it is reasonable to assume that the possibilities are evenly spread, even if only because the mathematical calculations in making it anything else become so arcane as to wander into irrelevance.

So let’s assume that a deflationary spiral is just one possibility. Hyperinflation is another possibility. It is quite plausible in countries that are printing money but not so logical in others.

This is the bane of the average investor. Every day, we are bombarded with news headlines and commentary that confirms our worst fears – and that the only safe investment is a wheelbarrow full of gold and a gun.

Let’s agree that the 17 members of the European common currency are in an awful pickle. If Brussels (read : Germany) continues to prove successful in its backdoor takeover of the peripheral countries (Greece and Italy down, Spain and Portugal to follow?) then maybe all of Europe will speak German and economically all will be well. Europe does not have a happy history of letting sovereignty go quite that easily, so there remains a large and unmeasurable risk that extreme reactions will be provoked before this debt crisis is over. Similarly, the United States has a structural debt issue that is only being covered by printing money, and the manner in which it is being done is generating even greater income inequality within that country. So far, Occupy Wall Street has been relatively tame but it is in times such as these that extreme elements get a far greater say than they would otherwise receive. As two of the largest economic blocks globally, gyrations in these areas have the potential to derail any good stories from other parts of the world.

The end result of these points is that the risks people are most worried about are the risks that are most difficult to measure. In effect, they have a low probability of occurring but should they occur then they will have a very large impact. Even the impact cannot be calculated or guessed at, and this is the aspect that has investors, analysts, politicians and commentators worried.

This is compounded by the problem of working out what to do if you are concerned with these extreme outcomes because a deflationary spiral needs very different strategies to a hyperinflation spiral.

Now, more than ever, is a time for each investor to have a good long think about what they want to achieve, and how much attention they want to pay to these ‘tail end’ risks. IF the answer is to go hyper-conservative then that person must be prepared to miss out on at least part of any recovery that may evolve. On the other hand, if a person is prepared to close their eyes to this tail-end risk then they need to be prepared for the outcome should such events transpire.

If we put aside these two extremes then a more certain outcome  would be a very slow and choppy recovery of the global economy and one in which the repective winners and losers are anything but certain.

In this case, we are looking to accumulate quality income producting assets at reasonable prices over time, so that we can obtain any price appreciation that may come about when the world takes on a “less risky” perspective. If we take that approach then the world is pretty much where it has been for many, many years now.

Our expectations of what money will and will not do may need to be adjusted though. Blithely assuming residential property will rise at 10% pa and that bond funds will continue to provide returns on par with equity investments seems a charmingly naive approach in such a climate.

The risks that have always been present are still there, it’s just that we are currently facing a few systemic risks that may be quite unlikely to come to anything but if they do, the results would be very bad indeed.

Further Reading

The US sharemarket is currently on the lowest P/E ratios since the March 2009 GFC low-point. However, it would fall another 43% if price to earning ratio’s were to go back to those of the recession of the early ’80’s.

Tulip Mania http://en.wikipedia.org/wiki/Tulip_mania

South Sea Bubble http://en.wikipedia.org/wiki/South_Sea_Bubble

Stockmarket crashes – a fairly long list http://en.wikipedia.org/wiki/List_of_stock_market_crashes