“Fat tail risks” are risks with low probability but potentially massive impact. In statistics, a normal distribution assumes that all values in a sample are evenly distributed above and below the mean and that the probability of an extreme event occurring is only 0.3%.
Many financial models have a normal distribution as a starting point. However, the market is far from perfect and is heavily influenced by unpredictable human behavior. For this reason, disruptive events that should only occur very sporadically occur relatively more frequently than one would expect.
What are the biggest geopolitical fat-tail risks that investors and policymakers should be concerned about today?
The Gaza War
There are plausible possibilities for an escalation of the Gaza war that could have global financial and economic implications. Iran claims it doesn’t want a regional war while having one or more fingers in the Syria, Iraq, Hamas, Hezbollah and Houthi pie. It may decide to add fuel to this pie, increasingly cornering Israel and implicating the US. But if Tehran overplays its hand, there could be attacks on Iran by Israel or even the United States
This could impact the global economy through skyrocketing energy prices. In fact, Iranian oil exports have surged recently and fossil fuel transport through the Strait of Hormuz may be at risk.
The latter can also happen without direct Iranian involvement: Yemen’s Houthi rebels, for example, are under the influence of Tehran and could decide to attack oil tankers, which could cause insurance premiums to skyrocket or insurers to refuse further deliveries from the Middle East to take over .
On the one hand, these developments would be positive for traditional fossil energy companies (particularly those that are less or not dependent on oil and gas from the Middle East, such as US shale producers). On the other hand, high oil and gas prices could give a boost to green energy producers. And higher oil prices would further reduce the profit margins of energy-intensive sectors such as transport and aviation.
This would make the job of central banks much more difficult: just when inflation appears to be on a downward trend, it would experience another upturn. If economic growth continues to decline, central banks would face a dilemma: they would have to tighten policies to keep inflation under control or loosen them to avoid a deep recession that could lead to a credit crunch due to excessive debt. which would only continue to rise if governments reintroduced support programs to help households cope with high energy prices.
If things got completely out of control in the Middle East, we would undoubtedly see a flight to safety. Gold would benefit as a hedge against rising inflation and as a safe haven not tied to the government; The dollar and US Treasuries could also be attractive – but it would be no surprise if appetite for US assets waned because authoritarian states fear that their dollar assets are not safe from US sanctions. Another reason is that the outlook for US politics and the US fiscal situation is not particularly reassuring, due in part to Donald Trump’s increasing chances of a second term in office and the high likelihood of stubbornly high federal deficits.
The Ukraine War
Many are convinced that the conflict between Ukraine and Russia has reached a dead end, and that is unlikely to change any time soon. This corner could have a significant impact on financial markets in two ways.
First, Ukraine could succeed in cutting off supply lines to Crimea, which would significantly weaken Russia. Ukraine’s success will not automatically lead to optimism in financial markets; It could backfire if investors fear Vladimir Putin will strike even harder if he feels cornered. Second, Russia has an enormous quantitative advantage in weapons and troops, which would become increasingly apparent as Kyiv’s allies reduce their support. This could lead to a further advance of Russian troops, putting even more pressure on Ukraine’s allies or prompting Kiev to take riskier measures such as a desperate offensive.
An escalation of this war could also endanger global energy supplies. Despite all the sanctions, Russia remains an important energy exporter; Europe has significantly reduced its Russian oil and gas purchases but remains among the top importers, although China, India and Turkey are now Russia’s biggest customers. While Europe was most vulnerable at the start of the Russian invasion due to disrupted energy supplies, China and India could be hit harder now that Europe’s gas reserves are more than 99% replenished.
Should the Ukraine war make headlines again, it will likely hit European stocks relatively harder than US stocks, as was the case after the invasion in February 2022. (European stocks, however, recovered far faster and stronger than U.S. stocks, in part because Europe is looking for alternatives to passing on Russian energy faster than expected.)
Taiwan-China relations
Tensions between Beijing and Taipei have continued to rise, with some U.S. military officials fearing war in the next few years. Chinese head of state Xi Jinping will at least want to wait for the elections in Taiwan at the beginning of next year. If the more pro-Beijing opposition wins, military action is likely to be postponed for a long time, and Xi argues: “Why risk an extremely costly, bloody and unpredictable war when I can gradually conquer Taiwan through the political route?” Currently, the ruling party seems to be heading towards a victory, meaning tensions could rise sharply.
A scenario with a blockade or even an invasion is not excluded. Xi sees more and more regional countries uniting against a more assertive China. To avoid an excessively united front later, he might decide to try to bring Taiwan under Beijing’s control sooner while the West is distracted by two more wars.
Beijing could decide to impose a blockade and tightly control the sea and air space around Taiwan. Trade and shipping between Taiwan and the rest of the world could be significantly affected as freight forwarders and insurers would become cautious about transporting goods within Taiwan. Beijing could also aim to provoke Taiwan into firing the first shot, or it could assume that the Taiwanese people would force their politicians to agree, slowly but surely causing the island to suffer the same fate as Hong Kong.
In a more extreme scenario, China could decide to launch a direct military invasion. It is not a given that the international community would immediately or unanimously condemn such an action, as only about a dozen countries recognize Taiwan as an independent country. The big question is how the US – which, by the way, is not one of those dozen – would react; America is deliberately pursuing a somewhat ambiguous Taiwan policy. However, President Biden has clearly – some would say too clearly – expressed his support for Taiwan should China attack it.
Financial markets would panic in the extremely uncertain period that would accompany a blockade and certainly an invasion of Taiwan. In both scenarios, the yuan would come under strong devaluation pressure. The euro, dollar and yen would likely be considered safe havens, although the yen could be avoided given Japan’s proximity to Taiwan and China.
Trade disruptions, downed production lines (90% of the most advanced chips are made in Taiwan) and sanctions against China would cause massive losses to stocks worldwide. Technology companies and the automotive industry, for example, would take the hardest hits. Demand for US and European government bonds is expected to increase sharply, putting downward pressure on long-term interest rates.
Gold could be viewed as an even greater safe haven than Treasury bonds because the risk of the U.S. in particular becoming embroiled in war would pose not only an immediate threat to the U.S. economy and U.S. security, but also the prospect of one A significant increase in defense spending is driving up national debt.
Finally, oil prices would rise significantly as a third of global oil trade and half of all LNG travel through the South China Sea. At the same time, however, a war over Taiwan would likely plunge the global economy into a deep recession and put pressure on energy demand.
Andy Langenkamp is a senior policy analyst at ECR Research, a financial advisory firm, and ICC Consultants, a financial advisory firm, both based in the Netherlands.
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