Looking out for icebergs
Looking out for icebergs in the Global Economy is a guest post by Anne Richards, Chief Investment Officer of Aberdeen Asset Management on a wealth management topic for Investment Quorum.
The story of the Titanic shows us that, despite their size, icebergs can be surprisingly difficult to spot. That’s because while all may appear calm on the surface danger may lurk beneath the waves. Spotting risks in the global economy can be just as tough and our tools for finding potential hazards even less evolved.
The health of economies is usually assessed using aggregate measures such as inflation or Gross Domestic Product (GDP). But these are blunt tools at best: the inflation experience of the lowest and highest income brackets in a country can be very different, while aggregate measures of GDP can ignore the very important effect of demographics. Japan is an interesting case in point. Despite spending many years hovering around zero inflation or worse, with very low GDP growth by international standards, it has maintained high standards of living and low levels of unemployment, largely because GDP per capita has held up extremely well. In an aging world per capita measures will have increasing importance. Adding to the confusion is uncertainty around how well traditional tools for assessing economic activity are able to assess the virtual, online economy, while there is a growing sense of the need to reflect societal issues such as income inequality in an overall assessment of economic health.
Assessing financial risk is no less problematic. Our methods rely heavily on quantitative techniques which largely revolve around the premise that price volatility is a perfect proxy for risk. But short term price volatility may be a poor proxy for other material risks such as credit, liquidity or bankruptcy. It does not accurately reflect the risk of a permanent loss of capital, the risk of losing money which can never be recovered. In the world of oceanography, researchers now use satellite images to try to spot icebergs from space. We too need to find a new perspective which give us a broader view of risks, incorporating both qualitative and quantitative methods; effective risk management is both a science and an art. It involves both mitigation and contingency planning. The fact that an event is predicted to occur only once in 200 years is irrelevant to the investor if this happens to be the year.
These are important considerations because in many senses, in financial market terms we are now navigating unchartered waters without the benefit of satellite images. Quantitative easing (QE) stopped the financial system from freezing over, but as the warm, balmy liquidity QE has provided for several years is withdrawn, who is to say where the icebergs will form? The Federal Reserve balance sheet has expanded to roughly $4trillion, or roughly four times its average, pre-crisis size. And it is not alone – other central banks have played their part. There is no rulebook for contracting a balance sheet to this extent to return it to “a normal size”. All anyone can say with certainty is that it is unlikely to be plain sailing.
One of the greatest faults of the financial services industry is our tendency to believe in our own invincibility. And that can apply as much to our own business as to the assets that we manage on behalf of others. Despite high barriers to entry, including regulation, our industry is no less vulnerable to disruption than others. Technology is opening up new distribution channels and “Fintech” is the “buzz word du jour” across the industry. The Titantic sank not just because it hit an iceberg but because its makers believed it was unsinkable. Our industry can show signs of worryingly similar complacency.
Neither navigating the open sea nor financial markets will ever be risk free, but there are things we can do to understand those risks better, develop better tools to manage them more efficiently and finally to ensure adequate contingency plans when they turn into a reality. That way, when the cry goes up to “man the lifeboats” we have a better chance for surviving choppy seas.
Anne Richards, Chief Investment Officer
Aberdeen Asset Management
This is a guest post and the views here do not always necessarily concur with those of Investment Quorum. In fact, it is very often the case that we may be largely in disagreement but we respect the opinions of others and value their contribution to the wealth management debate. Guest posts may appeal more to some than others and may often have an industry, stock market or sector knowledge expectation.
This article was kindly provided by Aberdeen Asset Management and was originally published in Institutional Investor on 4th October 2015.
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