Take event risks seriously while building portfolios

Event risks in the form of natural disasters, acts of terror or political upheavals happen suddenly and can cause huge volatility in markets.

This volatility can wipe out portfolios, especially leveraged ones that are constructed with the assumptions that everything is going to be normal. The current world situation came unforeseen upon investors and market volatility is causing concern. How does one tackle such unforeseen events?

The earthquake and tsunami in Japan leading to a nuclear power crisis and the Middle East political revolution leading to flaring up of oil prices are unforeseen events which are impacting markets at present. Can these events have long-term impact on asset prices? The answer is yes.

Investors should not write off these events quickly and should position their portfolios with risk premiums built for such events. The Japan disaster has the impact of derailing the third largest economy in the world. The nuclear disaster is taking its effect on nuclear facilities in other parts of the world with Germany shutting down its older plants leading to a surge in electricity prices. Power shortages in Japan can impact manufacturing activity leading to lower consumption of commodities by Japan in the immediate future. Japan being a large trading partner with the rest of the world will see exports shrink, leading to shortage of supplies to the global market, which can add on to inflation. Japan could also sell its assets held globally to fund its rebuilding efforts leading to fall in asset prices including rise in bond yields in the US and eurozone where Japan holds most of its reserves. India will be impacted on the trade front as well with imports and exports from and to Japan being affected. The first impact is already being seen with software majors recalling their employees from Japan. Hence, Japan will affect markets till such time the country settles down.

The Middle East crisis is taking a turn for the worse. Bahrain is seeing more protests and the situation is becoming ugly. Saudi Arabia is worried over the protests spreading to its shores while Libya unrest is not looking to die down soon. There could be conflicts with other countries as well if there is interference from abroad. Oil supplies are likely to be constrained as long as the conflict continues leading to oil prices trending at higher levels. Oil prices remaining at higher levels or even trending higher will impact the global economy which is already seeing effects of the spike in oil prices on inflation.

The significant part of these events is the lack of ammunition from both governments and central banks to counter these events. Governments are borrowed to the hilt and central banks of the developed world have kept interest rates at all-time lows.

There is no room to cut rates and pumping money into the economy is not a long-term solution.  Such events give no room for economies to come back to an even state leading to further worsening of the fundamentals.

Investors must take into account these event risks in their portfolio and act accordingly.
arjun@arjunparthasarathy.com