As a result of the two market crises of the past decade, it has become evident that a more holistic way of looking at risk is critical, as is having a more robust and dynamic decision making framework.
In addition to incorporating multiple risk measures, it’s important to pay attention to macro factors that can impact market outcomes and potentially lead to what we would call, “extreme risks.” It’s equally important to have decision making bodies that are more nimble and flexible in their decision making as markets will remain volatile and success for plan sponsors will be somewhat dependent on their response.
In 2009, Towers Watson identified 15 “extreme risks” that, while unlikely to occur, could severely affect economic growth and asset values and returns. A framework for risk assessment requires determining what could cause these events, whether the causes are plausible and what the consequences could be if they did occur. As investment consultants, we are interested in the impact on asset returns and, in some cases, the effect on liabilities.
The risks (as shown below in the table) can be grouped into three main categories: financial, economic and political. While other potential risks exist in categories such as longevity, operations, processes or systems, we do not consider them in this article.
Financial
Financial extreme risks are solvency related—whether a financial institution will be able to pay its debts with available cash. The interconnected nature of the financial system and its high leverage levels mean that insolvency for one institution can quickly become a systemic problem as was the case with Lehman Brothers. Financial risks can be self-generated and transmitted to the real economy through falling asset prices. Alternatively, they can be generated by a recession in the real economy, which reduces income and is thereby transmitted to the financial sector through a default on loans (corporate and personal).
Financial risks generally result in declining asset prices as companies sell whatever assets they can to raise cash. The highest-quality bonds (usually sovereign) are preferred as investors seek safety in quality assets. This was certainly the case in 2008. Historically, gold has also been a good hedge against financial turmoil as it acts as a store of value.
Economic
Economic extreme risks are less homogeneous and range from a deflationary depression to hyperinflation and a return to a gold standard. In a deflationary depression such as was experienced in Japan, government actions cannot return the economy to sustainable growth. This is a bad environment for asset prices, and will likely result in a flight to the safety of sovereign (nominal) bonds.
The other economic risks essentially assume that government actions are successful, but at a price. Should stimulating the economy require government debt to grow to an unsustainable level, there is the prospect of sovereign default or hyperinflation—either of which would be devastating for asset returns. It’s likely that inflation linked bonds would be defaulted on in hyperinflation. Gold may act as a hedge against these risks, though this is not certain.
Political and Other
The third category comprises those without financial or economic causes. Most are political, but other scenarios include climate change and killer pandemics. These scenarios are much harder to monitor and predict and, in most cases, would be hard to hedge.
For example, hedging the breakup of the euro could involve the use of credit default swap contracts, introducing new risks. Adding food and water exposure to a portfolio may hedge climate change, but as they gain in value, confiscation would become a risk.