Black Swan Investing and the breakup of Europe
This isn’t going to be a thematic post on how to profit from Europe’s breakup, despite the sinister title. Instead, it’s a potpourri post – a mashup of different ideas I have right now and want to run by you to organize my thinking about them. I used to do this a lot more in the past – and I found it useful; I hope you did too. So for lack of a coherent theme, I chose the title above. Here goes.
A lot of what I have to say actually is about Europe. But there isn’t an overarching theme. I want to put the refugee crisis, populist politics, the Greek debt crisis and the Italian banking crisis all together here. I also want to talk about the strong dollar and Chinese interest rates. I haven’t figured out an organizing principal. But I then I saw a tweet by Ed Conway on how Crispin Odey lost 48% of his money this year despite his leading what is supposed to be a ‘hedge’ fund with good returns in good and bad times. And so I thought I would make this post about what these events mean for macro investors.
Take a look at this tweet right here. I have had this pinned to my profile on Twitter for a while now.
Think of this bull as a black swan and the spectators as investors pic.twitter.com/TSlKlYuaJR
— Edward Harrison (@edwardnh)
This is how I am thinking about macro investing these days. You’ve got the bull (market) running around its ring in the bull fight – with the bullfighter directing it here and there. Let’s say the bullfighter is the collective policymaker set. In this clip you don’t see the bullfighter. He’s lost control of the bull.
And we the investors say to ourselves, “It doesn’t matter. It’s only a temporary loss of control. The bull is in a ring. What could go wrong? I mean the bullfighter could get hurt, sure. Just bring a new bullfighter in to replace him.” But then the bull heads for the side of the ring. He veers abruptly at the last second and jumps out of the ring in a completely different location, mauling any and everyone in his path.
That’s what will happen to investors when a ‘real’ black swan event happens. This is what happened to Crispin Odey. But will it happen to you and me, and everyone else? That’s question #1. Will it happen as a result of something in the US — in Europe — in China — or somewhere else? That’s question #2? I’m going to focus on mostly Europe here.
I was in Greece twice last year, the first time for the No vote in the Greek referendum in July and the second time for the parliamentary elections in September. The first vote was a bombshell that threatened to explode the eurozone. But then the ECB put down the hammer and Greece fell into line – Yanis Varoufakis falling on his sword as the sacrificial lamb. So when the second vote happened, I said at the time Greece would cease to be a talking point in Europe – cease to be the country that imperils the European project. And this has proved true. In fact, I haven’t written about Greece once at Credit Writedowns since July of 2015.
Apparently, Yanis Varoufakis believes the same thing – because he wrote a piece today saying so. I like how he put it too.
Since the summer of 2015, Greece has (mostly) dropped out of the news, but not because its economic condition has stabilized. A prison is not newsworthy as long as the inmates suffer quietly. It is only when they stage a rebellion, and the authorities crack down, that the satellite trucks appear.
Since Syriza caved to the Troika after the July 2015 referendum, Greece has ceased to have real market-moving consequences. Tsipras is now a conventional politician – assumed likely to toe the line. And so there is no bull-ring jumping that will happen in Greece. Case closed
Now if you look at how risk assets have been performing, you would think the risk is not there. My post on tail risk just a week ago showed you how, globally, post-Brexit and then again, post-Deutsche Bank, tail risk had been taken off the table as a concern. But there is still tail risk out there — in Europe and elsewhere.
Take Italy, for example. Reuters is saying that Italy is seeking to borrow 20 billion euros to prop up its banking sector. The bailout could happen as soon as next week. But how’s that going to work under EU rules? Where’s the bail-IN? I know German Bundesbank head and ECB policy member Jens Weidmann has said that he has no problem with Italy’s bailout – or at least that’s my interpretation of recent comments he made. But, still, I think this is still a thorny issue that markets are glossing over.
Then there is the refugee issue. The inter-relationship to Italy here is that the refugee issue is driving voters away from the center. I was listening to the Dutch evening news broadcast Nieuwsuur from Sunday and they were talking about the refugee issue with a guy who used to represent the SPD in the rust belt town of Essen. This guy basically said he had decided to become an Alternative for Germany candidate because the social democrats had lost their way on refugees and other issues his voters cared about. For those of you who read German, here’s a link in the Rheinische Post about his conversion. That’s the same kind of drive away from the center that blocking a bailout in Italy could create.
Now I know Merkel seems safe – if a Grand Coalition of CDU and SPD is the default option in Germany. But what if the electorate is radicalized by the refugee issue, despite the good economy in Germany? The Christmas Market assault in Berlin is a flashpoint that bears watching in this context. And the euro has falling to a 1.03 handle against the dollar on the back of it – and the concept that a Grand Coalition may not actually happen.
So that’s Europe – a place where there is tail risk hiding and waiting in the shadows of your portfolio.
Of course, the same is true in China. I wrote about this yesterday. And today, if you look at the interest rates in China, it is even worse. 1-month HIBOR is up 89 basis points to 10.29%, an 11-month high. 3-month HIBOR is up 36 basis points to 8.82%, also an 11-month high. Now I don’t know if that yield curve inversion in a Chinese context is meaningful. I do know, however, these punishing rates won’t help the Chinese keep growth on target. Something’s gotta give, either the target – and that could happen in 2017 – or the currency. And if the currency gives way, it sets China up for a trade war with Donald J. Trump.
I think Crispin Odey’s fund meltdown is understandable in that context. What he has demonstrated is that a lot of global macro investing isn’t really about getting higher returns for the same or less risk – Alpha. It’s about taking on more risk, hidden risk, lurking in the shadows of your portfolio – hidden Beta. The question is when that risk is crystallized and how many punters get caught out as a result. The low volatility numbers today won’t last. 2017 will be a good year for those who actually do have more alpha and not just more risk.