The Davos Special

The price of instability

Are markets mispricing geopolitical risks?

Panelists: Nouriel Roubini, professor of economics, New York University; Natalia Ann Jaresko, finance minister, Ukraine; Martin Senn, group CEO, Zurich Investment Group; Paul Singer, founder, Elliott Management 

Moderator: Moisés Naím, Carnegie Foundation 

Moisés Naím: Geopolitical risks are not derived normally from the behaviour of markets, financial institutions and economic agents but risks that come from decisions by governments or NGOs or pandemics such as Ebola. The question is, how are markets pricing these risks? Are markets assigning a correct value, are these risks being underestimated or overestimated? Of our four panelists, two are going to argue that markets are misunderstanding and mispricing these risks and the other two are going to argue that markets are in fact capturing these risks. Let’s hear our first panelist, Natalia Ann Jaresko, who is going to defend the notion that markets are not doing a good job of capturing risk. 

Natalia Ann Jaresko: History has shown that markets have often mispriced risk. The 2008 global crisis showed that the markets weren’t ready for what the systemic effect of that crisis would be and that the system was going to collapse. I think the Eurozone collapse is also misjudged and overpriced in time. I think there are three reasons why this mispricing happens. First and foremost, investors are reacting to their own market appetite and not necessarily to the specifics of what is happening. They are looking to their own portfolios, what they would like to achieve and where they are at that given moment. The second reason is perception. This emotional element is impossible to quantify. Finally, to a great extent, investors tend to move en masse. They move together in and out of markets and in the pricing. They could be right or wrong but not many people are going to buck the system. 

Moisés Naím: Professor Roubini, do you disagree with this? 

Nouriel Roubini: Markets are usually not efficient; there is mispricing. But the question is do markets misprice — worse than otherwise — geopolitical risks, as opposed to economic and financial ones. I am not sure about that. Last year, in Davos, people said that there might be a war between China and Japan. Markets were not pricing it. Guess what, that war did not occur and so far the tension has been reduced. There has been Ebola and other tensions in many parts of the world. The question is should markets price them in hugely when the probability is very low. Probably, markets are rational not to do so. 

Take the situation in West Asia. What has happened last year is a paradox because oil prices have collapsed in spite of the geopolitical situation becoming worse. But compare that with the past. In 1973, there was an embargo and oil prices tripled. In 1979, we had an Iranian revolution, another embargo and oil prices tripled. In 1990, we had the Iraqi invasion of Kuwait. There was a shortage in the supply of oil and oil prices spiked. This time around, this hasn’t happened. Why? First of all, there has been no supply shock in West Asia. That is because [the presence of] shale gas in North America has led to more production this year in Iran, Iraq and Libya. There is a supply glut and price has collapsed because of an imbalance between supply and demand. So, when you look at these risks, you have to think about them. Are they so large and significant in their economic and financial impact that the markets are not pricing them correctly? Of course, there is overshooting on the way up and the way down but markets are pricing these risks.

Moisés Naím: Paul Singer, do you disagree with that?

Paul Singer: So far, we have been talking about the markets as if independent actors, tens of millions of investors are pricing the markets. This is not actually true in today’s environment. And there are two major reasons why markets are mispricing geopolitical and other risks. The first one is very straightforward. The largest investors by far in the world’s stock and bond markets, all on the buy side of course, are the major developed world government’s central banks. And what they have done is distorted the price of financial assets so that you don’t know what the actual price is. So, I would actually put the word markets in quotes in this situation. 

In fact, the US Fed has purchased the majority of the issuance of government medium- and long-term debt in the post-crisis period. At first under emergency conditions but also as is the case in Europe and Japan because the fiscal authorities have not been taking the steps that every economist knows would be pro-growth on taxes, regulation, trade authority and education. Currently,
in Japan, the central bank owns 1.5% of the capitalisation of the Japanese stock market and it is about to embark on an even larger program. If it doesn’t work — meaning, restart growth or restore growth to pre-financial crisis conditions — the solution so far is to buy more, double down, and Europe seems on the verge of doubling down. 

The first reason is you don’t know what the price is in the absence of that buying. The absence of that buying is not millions of informed investors or investors that are trying to inform themselves about the correct price. And so what we have is — for example, in Europe — as we speak, the 30-year swap is trading at around 1.27%. If anyone thinks that a) that is a reasonable or fair price to invest to meet your investment assumptions, your actuarial assumptions, your liability assumptions over the next 30 years, I think that is just wrong; and b) if you accept that price as OK, what about the possibility of inflation? Inflation is partially a byproduct of some of these geopolitical risks that have been described and that we all know exist. 1.2% in Japan and 1.7% in Europe and 2.3% in the US doesn’t give you much room. 

The second major reason why markets are mispricing geopolitical and other risks is related to the first but is actually a different point. Given the pricing and given the still opaque and overleveraged financial system, the sensitivity, because of hurting, interlocking and similarly positioned investors, the sensitivity to risks is extremely high and I will give you an example in a moment. The cushion to withstand risks is very low. The example of course is the Swiss Franc. It is because of this positioning that from 1.2 when the cap broke, it went directly to 0.85 in 10 or 15 minutes and then in 15 or so minutes back to 1. So, these are two major forces. 

Moisés Naím: Martin Senn, Paul Singer says there is a concentration of power that drives what we call markets and that leads to misperception and mispricing. Do you disagree?

Martin Senn: I would say that we do not see any mispricing with regards to what the expectation is in the market versus our expected return. The major problem is that the global economy is still very fragile. There is limited ability to absorb major shocks and the very nature of geopolitical risks is changing. What is very important when we talk about geopolitical risks is to look at what is the impact on the business and not just on the financial market. How are you positioned with regards to supply chain exposure and the impact on the balance sheet? It is not just interstate conflict that is impacting the economy; it is natural resources, cyber espionage and populist sentiment in elections. This year, within the G20, 45% of the electorate is going through elections, naturally posing fairly drastic uncertainty. We have to differentiate between the short-term and long-term impacts of such volatility in the markets. To me, the question is really not that the markets are mispricing geopolitical risks but whether we have the full understanding of those risks and whether we are taking steps to build resilience. 

Moisés Naím: We have heard two well-argued positions that markets are mispricing geopolitical risks and we also heard two equally compelling and persuasive points of view to the contrary. I know that each of the panelists is eager to rebut and talk a little bit more about the issues. But, before that, let me ask you about the issue of inequality; is that driving and fuelling some of the geopolitical risks? 

Nouriel Roubini: Certainly, the issue of inequality is an important one, even if it is more of a slow-motion risk rather than a tail risk that explodes and has significant market risk instantaneously. We have to first understand why it is happening and I think it is a combination of factors. First of all, technological innovation is becoming increasingly capital-intensive, skill-biased and labour-saving. Second, trade and globalisation — whether you like it or not — reduce jobs and incomes of the low-skilled and unskilled; initially manufacturing jobs but now even services are becoming tradable. Many of those jobs are going offshore. Today, a radiologist in Mumbai can do the same job as a radiologist in New York for one quarter of the salary but software can replace that tomorrow and those jobs are going to be replaced. Third, we have this winner-takes-all approach that implies that the superstars in every field get more of the profits. So, all these things are happening but what are the consequences? I would say, increasingly, social and political unrest and instability. Second, inequality can even reduce economic growth because you are redistributing income from those who have a higher marginal propensity to spend — that are low-income and middle-income individuals — to those who have a higher marginal propensity to save; essentially, high-income individuals and/or corporations. There is an extreme Marxist view that says capitalism is going to self-destroy because inequality arising out of falling wages will eventually reduce consumption. You have to worry about it but I don’t think it is something that has direct market impact. 

Moisés Naím: Paul Singer, does inequality increase geopolitical risk?

Paul Singer: We should keep in mind that the driver of economic stability in the world and economic growth --— QE and 0% interest rates — has as its primary goal the boosting of asset prices. The secondary effect is an attempted boosting of inflation or growth. Growth may be a third-order effect. And so, what is happening is that the mispricing that exists in the world’s financial markets because of the forces that I described is exacerbating inequality and at the very time that investors are doing well to very well. The things that successful investors hold — bonds and stocks — are going up as a direct result of asset-inflation government policy. They are doing great. But the middle class in the developed world is not doing great. So, the inequality is a function of government policy and the social unrest is a function of the inequality and the seemingly growing distortion. 

Moisés Naím: So you would give government a greater role in increasing inequality while Roubini was emphasising more on technology, globalisation and other trends?
Nouriel Roubini: I want to make a comment on what Paul said. Asset inflation helps those with assets, but if you have not done the QE and if economies like the US are adopting the double- and triple-dip recession, then losses of jobs and income for low-income individuals would be more severe. So, more of the benefit has gone to the wealthy and if you think QE has helped only the wealthy, think about the alternative. If you had another recession, you would have a different impact.

Moisés Naím: Going back to geopolitical risks and their pricing, you had something to add, Roubini?

Nouriel Roubini: As Paul Singer said, yes, all advanced economies need to do structural reforms to increase growth. Regulation, taxation, you name it. But what is the constraint to low growth in the US, Eurozone and Japan? It is not the supply of goods because output is well below potential. There is a problem of aggregate demand. So, in the short run, you need to do monetary and fiscal stimulus to boost aggregate demand while you are working on the structural things that will increase potential growth. The two things are not inconsistent with each other. On the geopolitical risk, there are plenty of countries in trouble. But if you look at the markets, every time geopolitical risk rises, stock markets correct, currencies weaken, bond prices adjust, CDS spreads widen. Whether it is excessive or not, markets are actually quite sensitive to the fact that more than just economic news, political and policy mistakes have an impact. If anything, they are being more than fully priced in.

Moisés Naím: Let’s talk about another major political risk and how is it being priced, mispriced, understood or misunderstood and that is unanticipated low oil prices. What are some of the geopolitical consequences of low oil prices? 

Paul Singer: It is not an accident that a roughly one million barrels a day shortfall in demand has caused more than a 50% drop in the price of oil. There is a good case to be made that it is an engineered drop meant primarily to jostle not only the alternative energy industry companies but also geopolitical action against Iran, Russia and others. I think that is very important. Let’s talk of the US just for a moment. The alternative energy industry is perhaps the growth story or the capital spending story. Not that it is the bulk of it but it is a major source of growth in the US. The fact that the rug is being pulled out suddenly from the alternative energy industry in the US has consequences that will radiate out. I don’t think we can at this early stage assess all the follow-on effects. 

Moisés Naím: Professor Roubini, would you like to chip in with a final comment? 

Nouriel Roubini: I disagree with Paul on what are the motivations of Saudi Arabia. People argue that Saudi is trying to hit its enemies, whether it is Russia because it is not playing ball on Syria or Iran, which is the major geopolitical threat to Saudi. If you think about it, instead of losing hundreds of billions of dollars in reserves because you want to hit Russia, you can spend $10 billion-20 billion arming the rebels in Syria and get more out of it. The behaviour of Russia has not changed. With sanctions and low oil prices, Putin is becoming more aggressive rather than less. Why? Because his perception is that the West is out for a regime change like we had with Saddam in Iraq or Gaddafi in the case of Libya. If that is his perception, he is going to become more aggressive in West Asia, in the Baltic or in the case of Ukraine. 

In the case of Iran, it is going to be a loser as desired by Saudi Arabia or the US but low oil prices mean that Iran is more likely to do a deal with the West on the nuclear stuff because they need to do so to avoid the consequences of sanctions. Paradoxically, it will be in the interest of Saudi Arabia to have a high oil price so that the regime in Tehran doesn’t want to do a deal with the West. I don’t agree with the argument that the Saudis are doing it for geopolitical reasons. My view is that Saudi Arabia’s behaviour is that of an oligopolist doing predatory pricing. You keep the price low for a while and get rid of all the high marginal cost producers — the shale gas guys, Venezuela, you name it. You commit to a schedule of fixed investment and capacity so that everybody else is going to underinvest in capacity for the next few years. If you do that in the short term, you have low prices but in the long term, you have high prices and a larger market share. It is an economic and not geopolitical argument for Saudi Arabia. 


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