Maladjusted Risk Return

Should the possible consequences of financial market risks be weighed individually, strategically or collectively?

The Economist Intelligence Unit (EIU) is usually so level headed that its analysis borders on boring. But it finds the protectionist and militaristic tendencies of US Republican Party front-runner Donald Trump scary.

Regardless of your US presidential preferences, Trump can never be described as “boring”: one newspaper headlining the EIU’s results said, “A Donald Trump presidency could be as damaging to the global economy as jihadi terrorism...”

Despite the EIU’s presentation of the risks as discrete we are drawn, or perhaps have a responsibility, to assess the eventuality of one risk coming to pass and its impact on the other risks posed or to estimate the strategic threats of each risk in relation to others.

Contingent Risks

Some risks are contingent: if one occurs, there is a risk or an additional risk that another will follow. Does that compound the original risk or make the second risk, in effect, part of the first?

Some risks are strategic: there is not “cause and effect” but one risk coming to fruition may create risks, or indeed opportunities, in the revised scenario.

The EIU’s number one risk is China’s possible hard landing. In that event, the EIU’s number ten risk, a collapse in the oil sector prompting a future oil price shock, would loom large.

Oil and other commodities have fed China’s boom, the tapering of which has already seen deferral of major infrastructure investments in the oil sector. Tapering has also exposed extreme vulnerability among iron ore, copper and coal majors weighing heavily on stock market indices. The crystallisation of one risk, it seems could, create the conditions for the second.

Hubble, bubble, oil and rouble

What if we stir into this pot of gloom-mongering the perfect storms of one, or more, apparently unrelated risks, colliding in the same time scale? In unrelated events, in June British voters could steer the country out of the European Union. In 8 November US voters could elect Donald Trump.

A possibly resentful EU could stall a revised trade pact with the UK and the rest of the world may be less receptive to Britain’s new trade overtures than Brexiters supposed. A Trump presidency already promises protectionism. Could we anticipate trade barriers being erected world wide faster than Mr. Trump’s wall to halt the flow of Mexican immigrants? Or could Mr Trump’s supposed militarism colliding with Russia’s foreign adventures provoking a new “cold war” (EIU risk 2), trade sanctions or worse?

Runes ruined

In banking, asset management and corporate boardrooms, equity prices and bond yields are scoured, like the runes, to foretell the future direction of markets overshadowed by such risks as the EIU articulates.

Value at risk is calculated, hedging and derivatives strategies divined and papers written anticipating potential outcomes. But how realistic is it to calculate and put a price on the eventuality of a series of sequential, strategic, multiple or collective risks?

The EIU has spelled out individual risks, but not the knock-on effects of one risk coming to fruition triggering one or more of the others in the list.

Perhaps, in the current, volatile economic and political environment, the most important hazard markets face is being frozen in the headlights of the oncoming pantechnicon of risks.

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