Tuesday, July 7th, 2015

Coincidences Can Be Dangerous

Nothing in these Strategy Notes should ever be construed as a prediction but we may look back on June as the month when our recommended equity weighting peaked for 2015 and started to decline. All three asset allocation models – US dollar, sterling and euro – have equity weights which are lower than they were at the end of May. For all of them, this peaked at about 75% equity vs 25% fixed income (in line with the previous peak in December 2013) and has since fallen by about five percentage points.

This does not yet represent a massive flight from risk, but it could be the start of something bigger, and explanations are not hard to find. For some time investors have been worried about the outcome of the crisis in Greece, or the effects of an interest rate hike in the US, or an equity market crash in China. All of these have been widely predicted and the consensus is that the market is prepared and that the risks of contagion are limited. Broadly speaking we agree, but with one important caveat, which is that these assessments have been made on a standalone basis and take no account of the risks of cross contagion. In financial markets as opposed to the real economy, there does not have to be a thematic or causative link between these three problems. All that is needed is that they hit at the same time.

At the most basic level this is just an exercise in joint probability. Let us assume that the probability of global equities emerging unscathed from the Greek crisis is 80%, which is pretty good odds at 4/1 on. Let us assign the same odds to a happy outcome for the rest of the world after an equity crash in China and to stability following the first rate rise in the US. If these three events happen separately and investors have time to adjust, the odds of a satisfactory outcome for global equities stay at 80%. But if two of these events happen at the same time, the odds fall to 64%, and if all three happen the odds fall to evens (51.25%). The quantum of the loss still depends on what Eurozone governments do and how new Chinese retail investors react to their first bear market, but the probability of some sort of loss is materially increased if two or more crises happen at the same time.

The counter argument is that there is a negative correlation between the probability of the first two events (Grexit and a China crash) and the third. i.e. the Fed will delay a move if it thinks there are elevated risks of contagion. This may well be true, but such a course of action would not be without its own contingent risks and our schematic analysis has so far excluded additional risks which may be directly linked to the first two events, such as increased stress in the European banking system, or a decline in copper and crude oil price thanks to slower Chinese growth.

None this is easily quantifiable using conventional analytical techniques, which is why we think our approach is particularly valuable at times like these. Investors appear to have become a bit more risk-averse, not because their original analysis was wrong, but because these events are happening simultaneously. Coincidences can be dangerous, even if they are just coincidence. As ever, Shakespeare has a quote for this (from Hamlet), “When sorrows come, they come not single spies, but in battalions.”

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