Monday, October 13, 2014

Markets could suffer in the following scenario

Nouriel Roubini cites the reasons he believes the stock markets around the world could get ugly.

The Middle East turmoil could affect global markets if one or more terrorist attack were to occur in Europe or the US - a plausible development, given that several hundred Islamic State jihadists are reported to have European or US passports. Markets tend to disregard the risks of events whose probability is hard to assess, but which have a major impact on confidence when they do occur. Thus, a surprise terrorist attack could unnerve global markets.

Markets could be incorrect in their assessment that conflicts, like that between Russia and Ukraine, or Syria's civil war, will not escalate or spread. Russian President Vladimir Putin's foreign policy may become more aggressive in response to challenges to his power at home, while Jordan, Lebanon and Turkey are all being destabilised by Syria's ongoing meltdown.

Geopolitical and political tensions are more likely to trigger global contagion when a systemic factor shaping the global economy comes into play. For example, the mini-perfect storm that roiled emerging markets earlier this year - even spilling over for a while to advanced economies - occurred when political turbulence in a few countries - Turkey, Thailand and Argentina - met bad news about Chinese growth. China, with its systemic importance, was the match that ignited a tinderbox of regional and local uncertainty.

Today (or soon), the situation in Hong Kong, together with the news of further weakening in the Chinese economy, could trigger global financial havoc, or the US Federal Reserve could spark financial contagion by exiting zero rates sooner and faster than markets expect. The Eurozone could relapse into recession and crisis, reviving the risk of redenomination in the event that the monetary union breaks up. The interaction of any of these global factors with a variety of regional and local sources of geopolitical tension could be dangerously combustible.

While global markets arguably have been rationally complacent, financial contagion cannot be ruled out. A century ago, financial markets priced in a very low probability that a major conflict would occur, blissfully ignoring the risks that led to World War I until late in the summer of 1914.

Back then, markets were poor at correctly pricing low-probability, high-impact tail risks. They still are.