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A framework for thinking about tail risk

By Edward Harrison

I woke up this morning to tweets from the amazing Lisa Abramowicz indicating a sizable move into risk-off territory for global markets on the back of coronavirus concerns. And because I talked about faulty market structure related to one of those tweets, I thought I’d riff on a framework that Eurasia Group CEO Maziar Minovi presented me in an interview released today on Real Vision.

I am still in my ‘cautiously optimistic’ guise here. So, I am still thinking of a recession or credit crisis only as a tail risk in 2020 versus a base case. But, I cottoned onto some really good information about where some of the biggest risks in market structure reside when I listened to the Odd Lots podcast with Joe Weisenthal, Tracy Alloway and their guest Perry Mehrling last night. So I will end with some of that.

Risk-off

Let’s start with the tweets about high yield:

I am taking these tweets as evidence that we are in – at least a brief – risk-off phase. But, to add to that sense of risk-off is what is going on in the Treasury market:

I am a big fan of Abramowicz and Alloway, by the way. And I think Abramowicz sums it up nicely in her add on tweet:

People are on edge. And I hear the term recession being mooted again. People are also talking about how flat the yield curve has become, with the 3 mo. – 10-year spread that the NY Fed tracks at under 6 basis points.

US Treasury Curve 2019-01-28.png

Also notice that the curve is fully inverted from 6 months to 3 years.

Maziar Minovi’s vulnerability model

But all of these data points just point to risk off. None of them say anything about recession. For example, when Markit’s Composite PMI for the US came out Friday, the 53.1 read was above both a 52.5 expectation and the prior month’s 52.7 read. That’s not the signs of an economy nosediving. It’s more a sign of bottoming.

So I think the mental model that former Goldman investment strategist Maziar Minovi uses to think about tail risk makes sense. I have been thinking about what he told me for a week, as I interviewed him at the beginning of last week. But his video has just come out today. Here’s the link.

What he told me, as I remember it, is that geopolitics and event risks usually don’t matter at the global level. Yes, they can have regional or country-specific impacts. But, globally, he says, historically, there have been very few risks that have had sustained or meaningful impacts on the global economy.

Think of the global economy as a big tanker navigating the Rhein River that is very hard to maneuver off course. If it’s on course for decent growth, then you’re event or geopolitical risk is not going to push it off course enough for it to run aground. Tail risk matters only when the pre-conditions have deteriorated and there is “broader economic fragility”.

So where are we?

According to Minovi, there are some worrying signs regarding the global economy right now. For example, he noted that 2019 global growth was only 2.9%, the slowest since the financial crisis. And when you look at the IMF’s global growth forecasts, the delta is universally negative in terms of estimate revisions between October and the latest January numbers.

So, for me, what I heard Maziar saying is that, unfortunately, we do have vulnerability to geopolitical and event risk in 2020. And that’s why a recession or a crisis in 2020 is at least a reasonable worst case scenario to worry about. See “my constant end of cycle worries” post for how I’m thinking about this.

But, again, I am more optimistic today than I was a few months ago about the ability of the US economy to bottom and recover. And the Markit PMI data are in line with that optimism.

On the earnings side of things, Lisa Abramowicz comes to the rescue again with salient data:

 

My sense is that the earnings recession is now over, and that the capex recession may be now over as well – because the capex recession is a direct outgrowth of leveraged US corporates safeguarding their balance sheet during the earnings recession. See my post on BBB fallen angels and fake ETF liquidity.

That’s a very positive backdrop to 2020 event risk, where the wildcard is consumption growth that is presently attenuating toward the 3% nominal level. For me, that is where the rubber hots the road in terms of US vulnerability.

The global market structure vulnerability

But on the global side, I thought the Odd Lots podcast with Perry Mehrling was interesting. I love this podcast, by the way.

In this particular episode, Boston University Professor Mehrling was explaining what people call “The Money View” of the economy, in which settlement risk is the defining factor precipitating crisis. My biggest takeaway from the interview is that the intersection of actual liquidity – or settlement – risk and fears of solvency risk are what we need to worry about.

For example, the 2007-2008 Northern Rock, Bear Stearns, Lehman Brothers runs were about enough people fearing that each institution was insolvent to create a fatal settlement breach. Whether the institutions were actually insolvent was another matter altogether. The key to the crisis was that the companies failed to meet financial obligations at settlement and defaulted because enough people shunned them out of fear they were insolvent.

The solution, of course, is liquidity. But, Mehrling argues that regulators have addressed solvency and capital concerns more than liquidity concerns in approaching fixes to that crisis. And the upshot of that is that liquidity risk is still very much a problem.

In the wake of post-crisis fixes, Mehrling says what we now see is a move from unsecured lending for market-based financial settlement in markets like the Fed Funds market toward secured lending markets like the repo market. And that’s because regulators are pushing this because of solvency concerns that are motivated by a desire to prevent taxpayers bailing out banks as they were forced to do under the TARP arrangement. And what that means is that there is less liquidity because there is an over-dependence on repo for settlement.

All of this is happening against the backdrop of increased emerging market borrowing in eurodollars. The big post-crisis debt explosion has not been in the developed economies. It’s been in EM, and EM corp[orates in particular. I am talking to EM expert Rashique Rahman today for Real Vision. And he told me last night at dinner that a lot of this debt is unhedged, meaning that a strong dollar creates settlement risk for these debtors.

So, to the degree we see a strong US dollar, we will also see settlement risk in eurodollar markets. And that risk will be expressed particularly acutely in repo markets as secured lending is the vehicle of choice for those short of dollars to find liquidity.

So, if you’re thinking about geopolitical or event risk pushing a vulnerable global economy to the brink, you need to think about market structure vulnerabilities – meaning where liquidity crises could happen. And, if you are looking for where the next crisis will be, repo is the market to watch.

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Edward Harrison 7783 posts 575 comments

Edward Harrison is a senior Editor at Bloomberg. He is also the founder of Credit Writedowns newsletter, a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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