Tail Risk is Growing: But Not Where You Might Think

Tail Risk is Growing: But Not Where You Might Think

Risk is commonly measured by volatility as well as various types of interest rates and yields, for example the yield of credit default swaps. However, to what degree do these indicators reflect the real level of risk exposure in financial markets today? 

Traditional risk measures may not adequately recognize the true risk exposure hidden in today’s global financial system. They appear to indicate a very low risk world, if not even a risk-free world. Are they missing something?

The following chart should provide some food for thought. The yellow line depicts the real policy rate (the base rate adjusted for inflation) of the most important developed economies. It’s hovering just slightly above zero. The red line depicts the long-term index-linked (inflation-protected) bond yield, which basically reflects the real interest rate. It is negative.

Yet, while rates have continued to trend down, the level of global debt, public and private, amounts to 250% of GDP! The world has never been more indebted than today. This “tail risk” appears to be discarded entirely.


Source: Bank for International Settlements (BIS), Quarterly Review, Q3 2017

The rising debt level is the result of multiple decades of “easy money” policies across the globe. It has resulted in all kinds of distortions in financial markets and the global economy. Just one example of “something’s wrong”: The level of government debt carrying negative yields globally has risen to over US$ 9.5 trillion, according to Fitch Ratings. How does one interpret the fact that some investors are willing to pay to lend?

Bubble territory – time to cash in?

We are experiencing a rare synchronous growth phase in financial markets. Fundamental economic indicators look positive. And, asset classes across the board have been performing nicely, with volatility and interest rates at record lows. Meanwhile, several markets have reached “exuberant” valuations.

As correctly pointed out by Jared Dillian, of Mauldin Economics, in his recent article titled “The Everything Bubble”, assets across the board have been on the rise. Several may have reached “bubble territory”.

As prices continue to thread higher, investors are left in a conundrum. They ask: “Should I continue to invest to the tune of central bank stimuli, trusting in low volatility and the solidity of the global financial system, or should I implement downside protection, go short, or simply prepare to exit the market and go to cash altogether?”

Some financial advisors may give you that very recommendation – sell, cash in and wait on the sidelines to let this storm pass over. And, possibly, that might work. Unfortunately, this approach can be tricky; it may in fact increase your risk exposure.

First, timing markets is very difficult, if not impossible. While I agree that these markets look toppish and increasing the cash position can be attractive, there are caveats to that approach: Nobody will be able to tell you how long interest rates remain low and how high financial markets will go. Therefore, stepping aside may entail opportunity costs. Moreover, I’ve seen investors (including yours truly) pursue this “cash strategy”. As markets continue to rise, you may lose patience at some point, only to reenter the market at its peak and be penalized once more. Not good.

Secondly, so far, financial markets have been very good this year. If you have been invested properly, you will have achieved attractive gains in your portfolio. This gives you the firing power to invest in a little “portfolio insurance”. A variety of downside protection measures are available.

In the portfolios that we manage at BFI, we have reduced our exposure to bonds in lieu of alternative investments. And, we have started to protect our equity positions by employing suitable options strategies. I like to compare the related costs to an insurance premium, which allows us to stay invested in the market while still protecting our downside from a financial crisis.

Finally, holding a large amount of cash with a bank may expose you to the “debt trap” and the implications that come with it. In the next financial crisis, you can expect broad-based insolvency issues, a wave of de-leveraging, and then the next round of financial system rescue measures. Only that this time, it will not be a Bail-OUT but a Bail-IN rescue plan…

Beware of BAIL-IN risk!

This risk, in my view, is not priced into the markets. And, it is the risk most investors are not aware or simply choose to ignore. If you live in a country that has a high level of debt, which really includes almost all western developed nations, with few exceptions, you should have a close look at your country’s legislation regarding Bail-In.

Governments and central bankers are fully aware of the debt problem and the fact that the rescue plan of the last financial crisis may not work next time. In other words, all the dry powder was used up. Therefore, a new concept called “Bail-IN” was invented and institutionalized.

Around 2010, the G7 countries gave the Bank of International Settlements (BIS), or more specifically, the Financial Stability Board (FSB), broad powers to fine-tune the concept, lobby as necessary and spread this new magic recipe for “rescue” across the globe. As a first real-live test case, Bail-In was applied in Cyprus in March of 2013. It worked. It’s ready to be used again...

Ironically, it is currently the BIS that is openly warning us. In their most recent Quarterly Report, they again raised their concerns about the combination of overvalued financial markets and excessive debt levels. Nobody is listening.

What are the implications for wealthy investors? What can you do?

The implications are quite clear: the next round of financial system rescue will not be funded by tax-payers. That has been recognized as no longer politically feasible. Instead, the bill will be paid by wealthy citizens with lots of cash in the bank. That, after all, is just one other kind of wealth transfer and will be sold easily to the masses...

If you hold large amounts of cash with a bank that is not financially solid, and more importantly, if you hold cash with banks in a jurisdiction that is not fiscally sound, your cash is exposed to Bail-In confiscation measures in the next financial crisis.

Therefore, consider staying invested with proper downside protection. At this point, Bail-In legislation only targets cash, not securities. Therefore, you may choose to stay invested. If so, we recommend you restructure your portfolio somewhat to incorporate some downside protection as discussed above.

Alternatively, if you want to reduce risk by increasing your level of liquidity, then the least you can do is to invest in cash equivalent investments, for example short term government paper or money market funds, or even a liquid investment like gold or silver, which is currently not overvalued.

Finally, in consideration of the fact that legislation evolves over time and Bail-In rules may at some point extend to cash equivalents, hold part of your wealth in a jurisdiction that is fiscally sound, with rules that have high respect for private property and freedom. In other words, custody your assets and invest from a safer base outside of your home country.

Don’t procrastinate

I leave you with a quote I recently heard (I’m not sure who it’s from): “Procrastination is like a credit card – it’s quite a bit of fun, until you are presented the bill.”

Despite the low level of volatility and relatively positive economic indicators, financial markets are not considering some of the larger risks. We are witnessing an economic and political period that is best characterized as highly unstable and uncertain. While there is certainly no reason for gloom and doom, I do consider the past decades of “cheap money” and the immense level of debt as the number one enemy of freedom, wealth and prosperity.

The risks and implications of that debt, particularly in some of the major economic regions, namely America, the United Kingdom, Europe and Japan, are severe and imminent enough to deserve our serious attention. In view of these current big picture realities, asset protection and wealth preservation should be at the very top of your planning priorities.

Learn more about Frank Suess, BFI Capital, and how to protect and grow what is rightfully yours at BFICapital.com.