Handicapping Bubbles and Shocks

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Tail risk, the risk of an asset or portfolio moving more than three standard deviations away from its current price, appears to be increasing around the world. And some investors feel ill-equipped to manage this risk. This according to our latest poll of institutional investors.

Last week, we released the results of the Allianz Global Investors RiskMonitor survey, a comprehensive look at views on portfolio construction, asset allocation and risk. This year we queried 735 institutional investors around the globe representing a variety of different institutions: pension funds, foundations, endowments, sovereign wealth funds, family offices, banks and insurance companies.

The Other Side of Globalization
The findings of this year’s survey reinforced our view that global risks are increasing amid a complicated economic, geopolitical and monetary policy environment. In particular, this challenging climate was underscored by the survey results, which showed that two-thirds of the respondents believe that tail-risk events are likely to be more frequent due to the interconnectivity of global financial markets.

In addition, two-thirds of the survey participants also assert that tail risk has become an increasing worry since the 2008-2009 global financial crisis. Specifically, 62% believe tail risk is a “high” or “very high” risk. And 41% of the institutional investors surveyed believe a tail-risk event is “likely” or “very likely” in the next 12 months. Yet far fewer are “confident” or “somewhat confident” that their portfolios have appropriate downside protection for the next tail-risk event.

Known Unknowns?
Where are they seeing the biggest risks? The institutional investors we surveyed believe the most likely cause of future tail-risk events include oil-price shocks, sovereign-debt default, European politics, new asset bubbles and a euro-zone recession. However, this view varies by region. In the Americas, investors polled believe oil-price shocks are most likely to be the cause of the next tail-risk event, followed by US politics and European politics.

In Europe and the Middle East, new asset bubbles are believed to be the most likely cause of the next tail-risk event, followed by geopolitical tensions in Europe and sovereign-debt default. Meanwhile, in the Asia-Pacific region, oil-price shocks are perceived to be the most likely cause of the next tail-risk event, followed by sovereign-debt default and a euro-zone recession.

Interestingly, the timing of the release of the study coincides with an escalation of the ongoing debt crisis in Greece. That volatile situation aligns with the view that a sovereign-debt default and European politics are probable causes of future tail-risk events.

Heading for the Grexit?
So could Greece’s problems trigger a tail-risk event? Today, in light of the recent deterioration in negotiations between Greek government officials and Greece’s creditors, we see a material rise in the risk of a mistake by either side. We now have less confidence in a constructive outcome than we've had previously. As a result, we see increasing potential for a “Grexit”—Greece intentionally leaving the European Monetary Union—or a “Graccident”—Greece accidentally exiting. The accidental exit could occur if there's a run on the banks, which would trigger the termination of emergency liquidity assistance from the European Central Bank.

We believe that the ECB’s quantitative easing program and Outright Monetary Transactions will temper a lot of the bond and currency volatility, and some of the stock-market volatility. However, a “black swan” event remains a possibility.

This is relevant because, despite heightening risks, only 36% of institutional investors we surveyed believe they have access to the appropriate tools or solutions for dealing with tail risk. This lack of preparedness could be a recipe for bigger problems down the road for investors without sufficient risk management baked into to their portfolios. Obstacles hindering the adoption of appropriate tools include concerns about cost and a lack of understanding of tail risk.

At Allianz Global Investors, we remain committed to educating our clients in these important areas. And we strongly encourage both institutional investors and retail investors to fully explore ways to protect their portfolios from the negative consequence of tail risks.

Kristina Hooper is the US investment strategist and head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree in labor economics from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.

A Word About Risk: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.

There is no guarantee that an active manager’s investment decisions and techniques will be successful. It is possible to lose some or all of your investment using active management.

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.


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© Allianz Global Investors

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