Category: Featured

The emerging disruptive forces of technological, political and demographic change threaten to destabilise long-term investment performance. It will take special kind of capacity building and flexibility for institutional investors to benefit from disruption rather than fall prey of it.

We live in an age of unprecedented confluence of multiple disruptions. First, there is a generation of twenty-somethings set on disrupting virtually every industry using technology that did not exist or was too expensive a few years back, some of them succeeding in the process. Then there is the macroeconomic disruption brought by ageing population, stagnant productivity. There is the political disruption of Trump, Brexit and all the rest of isolationist and populist tendencies – evidence suggests that reversal of globalisation is progressing fast. Of course, the environmental disruption is hard to ignore. These trends happen very quickly in the historical context and reinforce each other.
What is the implication for the investment policy, if any? In the first issue of the Risk Wire this year, we attempt to take stock of all these disruptive trends and draw some conclusions in terms of the appropriate policy response.

Of all the global risk sources at the tail end of 2017, a sudden oil price shock arguably poses the greatest risk to institutional portfolios both in terms of its likelihood and the severity of impact. But perhaps the most troublesome factor is the complacency or lack of attention towards this risk; if anything, investors’ concern is over sharply lower oil prices.

The reasons for complacency could be traced to the widespread belief that the days of significance of oil as key commodity are numbered, and that we have already seen the beginning of marginalization of oil as energy source. The reality cannot be farther from the truth:

• the world is using more oil than ever before,
• electrification of transport will not matter at least until 2025,
• traditional oil producers have underinvested,
• shale oil producers face limits to productivity gains.

All of the above prompted us to carry out a 75% price hike scenario analysis using LINKS Mira ABM. Our conclusion is that the resulting environment will be toxic for fixed income instruments due to the inflationary pressure, but there will be bright spots to hedge with.

The global reflation trade has been in the centre of investor attention lately. One-off factors such as Brexit, commodity price increases due to government policy in China and oil price that rebounded from low levels, could explain much of this reflation. We audit the “trail” of reflation sources and identify a key vulnerability in the reflation narrative. We also introduce two risk scenarios in Mira ABM related to reflation: i) Disorderly Collapse of China’s Economy and ii) Collapse of Oil Price.

There is a modest global reflation unfolding in the last few quarters that has been hailed by investors and regulators as a welcome sign of economic normalisation. Should this process be sustained, it is fair to assume that the long-term interest rates will go back to their historical average values, thus putting an end to the era of financial repression.
Before getting too excited, we checked the source and sustainability of this reflation. Under normal circumstances, reflation is a reliable sign of improving economic outlook and earnings. In this issue of Risk Wire, we try to identify the sources of reflation in so far as positive earnings dynamics are concerned. We zero in on a key weakness of the reflation narrative and develop two “contrarian” scenarios for LINKS Mira ABM: “Disorderly Collapse of the Chinese Economy” and
“Oil Price Collapse”.

Is media coverage of potential sources of economic disasters proportionate to their likely impact on the economy and institutional portfolios? Investors form their perception of the magnitude of risk based on large number of public sources. Political biases, different estimation approaches and assumptions may result in unfair attention to things that do not matter and lack of attention to significant risks. We use Mira ABM to evaluate the impact of two widely covered global geopolitical risks with surprising results.

In this issue of Risk Wire we introduce two global risk scenarios:
i. Advancement of populist economic policies in the USA
ii. Hard Brexit
In contrast with our earlier work, these risk scenarios do not originate in our frameworks. Instead, we opted for collecting key generic global risks that attract the most attention in the investment community. We introduced these risks in Mira ABM* and found that despite their headline-grabbing nature, geopolitical scenarios appear to have no meaningful impact on a typical pension fund portfolio at least in the time frame of up to three years. Figure 1 represents a comparison of these two scenarios with two economically-driven scenarios covered by LINKS.

We extend LINKS Mira to the analysis at a portfolio and asset class levels. Mira enables us to value asset classes and carry out scenario analyses, such as the “Trump-effect”, presented in this issue. To establish credibility of the approach LINKS have consistently taken over the years, we also review the results of our documented recommendations over the 2012 – 2016 period as published in earlier issues of Risk Wire.

The common weakness of conventional stress testing and scenario analysis is their reliance on historical statistical relationships and the assumption of “other things being unchanged”. Unfortunately, in real life there is interactivity between agents, and hence the assumption of “other things being unchanged” often renders analyses futile.
Infrastructure spending is a case in point. Increasing volumes of infrastructure spending, other things unchanged, can result in larger profits in the economy. However, higher demand for workers will put pressure on wages in similar industries (e.g. mining) and result in shrinking profits elsewhere. The combined effect on the economy will depend on the relative size and structure of the economy as well as the size of the initial change.
An agent based model simulates these relationships and treats the global economy as an integrated network. Mira will pass a change in price and/or volume in one industry (the initial event) along the supply network and estimate the total impact on profits generated by all companies in all countries. To explain this in different terms: any event will impact all other economic agents along the supply chain. The cumulative impact of all these (inter-)related changes for all agents is what LINKS Mira measures.

Rising complexity in the world and structural breaks across markets require new non-stochastic approaches to scenario generation. The world is also too complex for simplistic ad-hoc assessment. We demonstrate the insights gained by implementing a supply chain agent-based model (LINKS Mira) and run the “China hard landing” scenario with curious conclusions.

As the world goes through a significant economic and political transformation, the number and complexity of risks and opportunities for institutional portfolios increase considerably. Gone are the days when the direction of globalization and integration was unquestionable, the question was just the differences in pace.
Increasing complexity creates additional problems for investment management. How does one manage risk and return in an environment where history is no longer a fair guide? Typically, economic scenario analysis and stress testing are the tools of choice. The common approach is statistical: basic models rely on stochastic processes with a random variable drawn from normal distribution, while more complex approaches involve multiple distributions, decomposition into multiple trend patterns and regime switches. A less common approach is designing ad-hoc descriptive scenarios in the context of the growth-inflation framework. Both approaches fail to deliver actionable results.