A good week to be thinking about risk

Tom Stevenson
Tom Stevenson Fidelity International

This is a good week to be thinking about risk. A string of natural disasters in the Americas and a potential man-made catastrophe in Asia coincide with the anniversaries of two events that caught us napping in years past. None of us will forget this day 16 years ago when the twin towers were brought down. Meanwhile, on Thursday we will mark ten years since the queues built up outside Northern Rock.

These are different kinds of risk. Some are acts of God while others are examples of human stupidity, greed or evil. But they are also distinguishable according to Donald Rumsfeld’s famous categorisation. The global financial crisis had been brewing for some time when Northern Rock succumbed to the credit crunch so it was a kind of known unknown. The same could be said of North Korea - we don’t know how the crisis will end but no-one can be surprised if something bad does happen.

By contrast, last week’s Mexican earthquake and the 9/11 attacks were really unknown unknowns. They came out of the blue. Given the predictability of the Atlantic hurricane season and the skill of the meteorologists, Harvey and Irma probably started as known unknowns but, as they approached landfall, they became very much known knowns.

We should probably be better at identifying and measuring risk than we are. The re-insurance industry is this week counting the cost of its propensity to under-estimate bad outcomes. The queue of weather events lining up to batter the Caribbean and US this autumn confirms that underwriters have been too sanguine about catastrophe risks.

The same tendency to treat reasonably probable events as ‘black swan’ tail-risks was clearly in evidence in the run up to Northern Rock’s failure a decade ago. Acting as if US house prices could never fall, or pretending that people with no jobs or income would not default in significant numbers, was an act of criminal complacency.

On the face of it, investors today are more attuned to the risks we face. Traditional safe havens are increasingly in favour as we look around for a port in the storm. Gold is currently priced at around $1,350 an ounce, close to a 13 month high, having risen by more than 15pc since the start of the year. In part this is a consequence of the weakness of the US dollar, in which the precious metal is priced. But it is also a reflection of bullion’s appeal at times of stress. My mother-in-law, who carried everything she owned from Pakistan to India in 1948 cannot read but she to this day knows the price of gold.

Other safe havens are gaining support. Treasury yields were last week standing at their lowest level since the uncertainty following last November’s Presidential election. US government bonds have enjoyed a good old-fashioned rotation from stocks into bonds as investors have started to take at least some chips off the table nearly nine years into the equity bull market. Perhaps less predictably, the Japanese yen continues to find support as a safe haven despite its obvious vulnerability to events in North Korea.

These traditional symptoms of a flight to safety are what you would expect. A few other movements in financial markets are puzzling and worrying in equal measure.

The first is the US Treasury Bill market. This is supposed to be the most predictable and boring element of government funding. It’s a super safe place to park your cash in return for a commensurately miserable income. But last week, the US Government had to offer a yield of 1.3pc to get a $20bn issue away. We hadn’t seen this kind of spike since 2008.

It was prompted by fears that the US debt ceiling might not be extended, causing the US Treasury to run out of cash as soon as early October. In fact a deal was struck but the volatility in this normally dull as ditch-water market is a symptom of a deeper malaise. Investors are now operating in a world where the normal rules no longer seem to apply. Just as, ten years ago, the financial world was turned upside down, today everything seems to be in flux - from the weather to geo-politics.

What’s even more curious, however, is the way in which, despite all the angst, some parts of the financial markets are experiencing an unearthly calm. The VIX index which measures the cost of insuring an investment portfolio against future volatility is becalmed. Even stranger is the safe haven status that investors have this year attached to technology stocks.

The enthusiasm of investors for tech is a sign of how different this ageing bull market is from previous ones. Today’s narrow leadership reflects a desperate search for predictable growth in an unpredictable world. The performance of the FAANGs - Facebook, Apple, Amazon, Netflix and Google-owner Alphabet - is understandable but it leaves investors vulnerable. Either growth returns and investors switch to cheaper cyclicals, or it doesn’t in which case the whole market will look overpriced.

So how should investors position themselves in today’s uncertain world? There is no substitute for diversification, putting together a portfolio of uncorrelated assets. When we looked at the performance of 13 different asset classes over a period of 20 years recently we found no years in which all assets performed badly at the same time. Even in the most volatile years like 2001 and 2008, some assets were able to offset the falls elsewhere. There is also no substitute for some cash in a portfolio. It holds its value and it keeps your powder dry.

And, finally, I’d recommend a dash of acceptance. We should worry about the risks we can mitigate and accept the ones we can’t.

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