Trail 17 — Tail risk
Jan 21 2022 (Editor — Sylvia Lo)
Over the last few weeks, the equity markets have receded predominantly due to inflation fears and rate hikes. As discussed last week, Rate hikes are not only expected — the Market has been repricing accordingly. However, this week, less probable but equally disruptive risks are making the headlines. These risks are typically called Tail risk events.
Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean. Given Portfolio returns are not normally distributed and have fatter tails, the chance of loss is higher than what is shown by a normal distribution.
The tail risk events which are becoming more probable are:
China’s Property Meltdown
China’s continued crackdown on its real estate sector shows few signs of stopping. As China takes measures to reduce the risk of a U.S style financial crisis, the Evergrande contagion has moved on to become the China Property contagion. With immense offshore funding to the Chinese real estate sector, the risks to markets in Asia and across the globe are rising.
China’s property sector shrank in the final three months of last year as its housing slump continues. The real-estate industry shrank a further 2.9% in the fourth quarter after a 1.6% contraction in the previous quarter, the National Bureau of Statistics said Tuesday. That was the first consecutive quarterly decline since 2008. Financial contagion in the sector is putting renewed pressure on President Xi to do more to insulate the nation’s stronger developers.
Monday was the worst day on record for dollar bonds for Country Garden Holdings Co., China’s largest developer by sales. Some of its notes fell to as low as 62 cents, while its shares sank to an almost five-year low. For the first time, the selloff has spread to stronger issuers like Longfor Group Holdings Ltd. and China Vanke Co. While panic seemed to ease on Tuesday, analysts expect the situation to worsen unless Beijing improves the real estate sector’s access to funding.
Russia’s invasion of Ukraine
War is coming. Don’t be fooled by last Thursday’s conversation between Russian President Vladimir Putin and his American counterpart Joe Biden, with its promise of further negotiations in January. Putin is bent on war, and this kind of diplomatic activity often continues until the eleventh hour before hostilities begin.
One of the immediate impacts will be on the energy market in Europe. Europe is currently facing one of the worst energy crunches in history. If Russia were to invade Ukraine, this would further disrupt gas supplies, leaving millions unable to afford heating this winter.
The spillover into Equity markets will be based on NATO’s response. While an all-out war with Russia is unlikely, volatility and uncertainty may drive markets even lower.
Previously tail risk events, also known as black swan events, were considered “bad” for markets. Then the Central banks came along and pumped trillions of dollars into the economy each time an event such as the GFC or COVID19 occurred. So tail risk events suddenly became “good” for the markets. With inflation surging, the money supply tap is unlikely to be the hero if these events do occur in the future. Trail risk events may very well become “bad” for markets once again.
Editors Corner
Taking Dogecoin to the Moon
This week, Elon Musk has again swayed Crypto investors to purchase DogeCoin. The meme stock surged ~11% after a tweet stating that Tesla will now accept DogeCoin as payment for Tesla merchandise. Just last year, Tesla accepted Bitcoins as payment for its cars but stopped in May 2021 due to the high environmental costs. A pattern we have seen many times before, it is always a roller coaster ride whenever Elon decides to promote a particular cryptocurrency.
Innovation falling out of favour
In recent months, Cathie Wood’s flagship portfolio (ARKK) plummeted as the markets continued their rotation out of growth stocks and into value stocks. Wood had promised investors annual returns of ~40% over the next five years, citing that her stocks are ‘in deep value territory”. The portfolio got lucky in 2020 as the markets favoured innovation stocks like Tesla, Coinbase and Robinhood. As inflation ramps up, coupled with a decreased money supply, the party has come to a screeching halt. Shareholders are starting to sober up and fully expecting a hangover.
Davos
As world leaders gather for their annual meeting this week, all eyes are on the World Economic Forum. As the world watches, we await decisions and outcomes that will drive trends across areas such as ESG, Space technology, COVID vaccines and Global trade for the remainder of the year.
Until next week.
