One of the things I enjoy about financial markets is the way they can blindside you. Trivial incidents turn into major headaches. And things that everyone was fretting about end up as non-events.
This week, we've seen that with Europe and the US. A default has passed off peacefully so far in one, while the possibility of default is causing panic in the other.
None of these directly affect Asia except for reminding us how good Asia's finances look so far. But wherever you invest, you can't ignore them.
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So how should we deal with risks like these?
Predictable Europe and unexpected America
In Europe, Greece has defaulted, as everyone knew it would. Politicians prefer to describe it as restructuring' and relief'. But it means some bondholders will get 20% less in present value terms than they are entitled too. That's a default.
It will be the first of many. I wouldn't have been bold enough to say that bondholders might eventually get back as little as 10-20% of their funds in some cases. But Sean Egan of Egan-Jones Ratings did in a recent interview with Barron's. And I rate his views as more credible than Moody's, S&P and Fitch.
More defaults will be coming for Greece, for Ireland, for Portugal and perhaps for Spain, Italy and even Belgium. And most people in the markets know that, even if they are underestimating the extent.
On the other hand, what's going on in the US is more of a shock. Yes, we've been hearing about the debt ceiling for at least six months. But everyone figured a deal would be struck sooner rather than later. Suddenly, we're a few days away from a deadline and it's not impossible that a deal won't be struck.
I have thought for some time that we would go down to the wire. As Ian Bremmer of Eurasia Group put it in a talk I attended a while ago, there is absolutely no incentive for either side to agree to a deal early. You just look weak by doing so.
You get maximum political mileage by waiting until the last minute. Hence a deal will be done, but very late in the day, and with haggling that both sides can spin to their supporters as a significant concession.
I still think this is the most likely outcome. But the fact is there are a significant number of people who welcome the brinkmanship and could even welcome a failure to adeal.
A large and vocal chunk of the Republican base wants very aggressive spending cuts and smaller government. One nuclear option to enforce this is to deny the government the right to borrow more meaning that spending has to be cut.
The odds of a US default are very small
So it's not impossible that there will be no deal by next week. Of course, even that doesn't necessarily mean the US defaults on its debt.
The August deadline may not be a deadline. First, some analysts have suggested that taxes have picked up enough that there is wiggle room through to September.
Second, there is no set priority to Treasury payments. So the government could put workers on temporary unpaid leave or hold off on paying suppliers and use the savings to keep current on its debt payments. (As mentioned above, this may be what the Tea Partiers would like to see happen anyway).
In the past, US states that couldn't agree a budget deal have issued IOUs which were then treated as a tradable instrument by the recipients. Perhaps the Treasury will do the same.
The Treasury is also reportedly taking legal advice on radical last-ditch options. For example, since the budget has already been passed, anything that stands against it being enacted may be unconstitutional and hence the debt ceiling can be ignored.
Given all this, the odds of a default look slim to me. And it's worth remembering amid the hysteria that this has happened before.
The Treasury missed a payment in 1979. The cause apparently was a late raise to the debt ceiling, plus some technical problems. The world certainly didn't end then although it's a different climate and financial system today and the knock-on consequences could be greater.
Why cash is good insurance
Still, the short answer is that no one knows exactly what's going to happen here. And perhaps more importantly, the fact we're now talking about the US and not Greece demonstrates again the way that large, unexpected risks creep up on you.
Who would have believed a couple of years ago that America's political system would become so polarised and dysfunctional that we can talk of the possibility of a default? Yet that's where we stand and even when we get through this, I think it's become very obvious that the US may have major institutional roadblocks to tackling its other problems.
So how can investors allow for risks like this debt ceiling debacle? There are two answers. One is, don't panic. If markets go into a tailspin, holding on to good assets and buying others cheaply will probably make you look smart in a few months.
The other rule is diversification. You own a range of different assets that should offset each other to an extent. By doing this, you give up the gains that would come with having all your bets on one outcome, but you purchase insurance in case things don't go as you expect.
And in doing this, keeping it simple is usually good. I read an interesting note by James Montier of GMO the other day, in which he talked about the growing market for tail risk products. A tail risk is an unexpected, unlikely event such as a plunge in the market.
Because of what we went through in 2008, tail risk is a common fear. Banks are capitalising on this by trying to sell tail risk protection to their clients. But as with most bank structured products, buying it is likely to be a bad move.
First, the more narrowly you craft a product to eliminate specific tail risks, the less useful it becomes, because it will only pay out in certain circumstances and those circumstances may not be what you feared (that's often the point with tail risks they're unexpected).
Secondly, it will probably be expensive. That's pretty much a given when a bank is trying to flog you a structured product anyway. And doubly so when everyone is fearful and trying to buy insurance.
Downside protection tends to be expensive at the best of times: put options tend to be more expensive than call options that have theoretically the same chance of being exercised.
Montier points out that, instead of buying tail risk protection on the S&P 500, you would have done better with a very simple strategy: holding a certain (fixed) percentage of cash. When stocks fell in price, you would automatically have deployed more cash into the market to keep the proportions of each asset in your portfolio constant.
The results are shown in the chart below. Having 30% of your portfolio in tail risk insurance (Montier uses a bet on rising volatility as a simple tail risk protector here) would have paid off very well in late 2008. But in subsequent years, the cost of funding it would have meant you returned substantially less than just holding the S&P 500 all the way through.
Meanwhile, holding 25% cash would have reduced your maximum loss. And keeping the proportion constant would have meant that you were buying at the bottom and consequently did well on the way up.
Obviously, this is a simple example and it's rather tailor-made to the 2008-2009 panic, which was the worst since the Great Depression. In reality, you're not just thinking about stocks and cash.
Bonds, gold, other alternatives also play a part. And you need to think about allocation within these asset classes as well. High quality dividend-paying equities can be helpful, because they throw off steady cash to be reinvested, reducing the amount of cash you might feel it's prudent to keep on hand.
So I don't mean this to sound like it's straightforward. But I think the principles of diversification; liquidity; simplicity; and buying when others don't, are clear. And a far better bet than panicking and trying to assuage that fear with expensive protection products.
We don't know what the future holds
Obviously, there is one flaw with this. Suppose you're invested in a market that just keeps dropping and doesn't eventually recover. Then you're just throwing more cash away.
This doesn't apply to anything that's happened in the US. But it would not have worked brilliantly in Japan over the last two decades. It would have been even worse in a country where the assets you were investing in were eventually worthless, due to state expropriation or other problems for example, revolutionary China or Russia.
This is where the second principle of diversification comes in that not everything goes into the same asset classes or the same countries regardless of how convinced you are by their value.
Unlike many people, I don't believe China is headed for collapse. I think it will have plenty of ups and downs but the right investments in China represent a great long-run prospect. But I would regard anyone who has the majority of their investments in China as taking on too much risk because I may be wrong.
Likewise, I would regard anyone who has the majority of their investments in the US as taking excess risk. We assume the US is a good long-term bet, because it has been over the past century. But extrapolating the past is always dangerous.
The US has plenty of issues to solve. And as noted, the partisan debt ceiling fight is not encouraging when it comes to how they will be handled. As the chart below shows, the US Congress is now more divided than at any time since the Civil War.
However, when we think about emerging markets versus the developed world or China versus India, or any of these very polarised debates, it's instructive to think back 100 years or so. Then, many investors were divided about which two countries would do the best. One was the US, about which no more needs to be said.
The other was Argentina, which has defaulted on its debt three times between 1980 and 2001. In the last couple of years, its stockmarket has been downgraded from emerging market status to frontier market. It has not been the long-term investment our grandfathers wished for.
So it's dangerous to have too much conviction. This isn't just true of countries. I feel equally concerned when people tell me they have all or most of their wealth in gold, oil or real estate.
That's a gigantic bet on a) having made the right call and b) getting out at the top. To me, that doesn't fit well with a world in which the unexpected often happens. A strategy that recognises this is the safest way to invest.
