Tail Risk

28/09/2012 at 3:12 pm

As readers know, markets enjoyed a period of relative stability across the summer of 2012. Despite the mild nerves shown over the last week or two, that stability has largely continued. But one of the events which has emerged to threaten it of late should serve as a reminder that this should not make us complacent.

Barcelona has voted for independence from Spain. A short year ago this would have seemed unthinkable – not to mention rather ridiculous. It is a classic “black swan” event. Everyone has been worrying about the breakup of the eurozone; no one has worried about the breakup of a European country since the dissolution of Yugoslavia. And as for the breakup of Spain in particular, who would ever have thought of betting on the Catalans over the Basques?

Of course, local politics is still politics. The region of Catalonia has been begging for a central government loan for some time. (It is surely a tribute to humanity’s persistency of spirit that so many of us believe in borrowing our way out of a debt crisis.) Perhaps their threatened secession is no more than a bargaining chip.

From the market reaction so far the threat does not seem too powerful, but it is instructive. This year might have been quiet – so far – but remember what happened in 2011: the Arab spring, the Japanese earthquake and tsunami, the referendum gambit in Greece and subsequent fall of the government … All these things were unpredicted and unforeseen.

Over the next few months, who is to say what might not happen? We wait anxiously for military action against Iran while there is civil war in Syria. Anti-Japanese sentiment in China has had real social and commercial effects. Then there is the enigma of North Korea. The dominant military power in the Pacific is the United States. Could it be possible that, one day, America will have to learn the lesson it taught Britain over Suez: that an indebted nation can only fight with the permission of its creditors?

It doesn’t pay to be too terrified, however. There is more to markets, and economics, than political events and natural disasters. A year after Suez, and Harold Macmillan was telling people they had never had it so good; according to the Barclays Equity Gilt Study, British stocks during the period 1956-1960 delivered a compound annual return of over 13% in real terms.

As we have all been reminded in recent times, volatility can be painful. But left field events cannot be planned for. Difficult as it can sometimes seem, the safest option is to back the fundamentals.

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