Who Let The Dogs Out?
If, like a few in Europe and many in Asia (all in Guam, Japan and South Korea for sure!), you are worried about either Kim Jong-Un or Donald Trump let slip the dogs of war, let me reassure you, you are not alone (and completely sane).
Past the moral argument that, in the words of Gen. Joseph Dunford, chairman of the US Joint Chiefs of Staff,
many of Axioma’s clients have inquired about the potential financial downside on global equity markets of an unlikely event.
As mentioned in an earlier post on a possible Trump Impeachment, geopolitical events are difficult to evaluate via stress tests as the scenarios developed are riddled with assumptions, taking you from cocky ignorance only as far as miserable uncertainty1. This case is particularly hard because of the two men involved and the obscurity surrounding each of their decision processes. Still, we keep calm and carry on modeling.
We began our attempt to model this war scenario by looking for some historical precedents in our database that could be used to calibrate the covariance matrix. A few ‘armed conflict’ cases came to mind such as the two Gulf Wars, the Arab Spring, even September 11, 2001. The latter resulted in a loss of 7.6% over a five-day holding period. The two Gulf wars played out over longer periods (a few months each) and reverted to a positive return by the end of the conflict.
We then looked at other domestic or regional crisis events we could use, such as the Japanese Earthquake of 2011, the Chinese Market crash of Q3 2015, the US Debt ceiling crisis, etc. Again, while those were representative of the kind of regionalization this conflict would represent, they did not capture the kind of global contagion effect this event would have and so we did not get much insight from this next batch of stress tests either.
Next we looked at a suite of market global crashes caused by financial crisis, such as the Russian Debt Crisis, the European Debt Crisis, the GFC, etc. Again, results varied widely depending on the spread of the crisis and the currency of the portfolio. In our minds, none were representative of the kind of reaction we can expect, and after some 60 different stress tests, we were no closer to a credible result we could defend. How do you model the unthinkable?
This is when we pivoted to a different approach. Rather than use historical scenarios, we should design our own version of the end of the world (or at least of common sense)2 and perform transitive stress test shocking several independent factors using the covariance matrix from the Brexit shock3 of June-to-October 2016 to calibrate the correlations. Using this period for correlation provided us with exactly the kind of panic leverage we needed to capture a global contagion effect. For example, shocking the Kospi index down by 20% using the last one year of data to calibrate correlations between Kospi constituents and the ones in our global portfolio only showed a 2.6% expected loss on the FTSE All World, but running the same test with the correlations from the Brexit period magnified these losses to 14.3%4.
The table at the end of this post lists the 11 factors we used in this stress test and the magnitude of the shocks applied. This is by no means an exhaustive list, our goal here is just to be directionally correct. Using this scenario and the correlations from the Brexit period produced a 7.9% expected one-day loss on our global portfolio5.
A war scenario cannot possibly be modeled with any accuracy, and any actual realized financial losses from this event would pale in comparison to the loss of life incurred. Our modeling exercise is therefore simply meant to propose a quantitative process for forecasting the potential losses on a global equity portfolio if a war scenario enters investors' collective consciousness. In other words, if investors see the ongoing Twitter diplomacy fail, raising the odds of war from an improbable possibility to a level even resembling a possible improbability, then these are the losses one could expect at that tipping point. If the probability of war rises past 50% though, all bets are off, and I’ll be on the next flight to Australia seeking asylum.
1Paraphrasing Mark Twain on the benefits of a higher education!
2The NYSE was shut-down on September 11 and only reopened on September 17. If war breaks out I would expect a similar decision in most of the stock exchanges in Asia – or at least those within reach of North Korean missiles.
3Most appropriate proxy since it represents reaction to a shock event.
4Ditto for each of the 11 factors we used in our stress test.
5The full set of results are available upon request.
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