Dr Axel Weber on risk and uncertainty

Very good lecture at LSE by Dr Axel Weber on uncertainty – well actually on ‘The interplay of markets and politics’, though his argument was that these equal uncertainty.

Some points:
– traditionally the distinguishing sign of mature as opposed to developing markets was that in mature markets you focussed on economic issues and did not need to worry about political problems. However, this has now changed: major political changes such as the Brexit vote and Donald Trump’s election to the US Presidency have shown that developed markets are as sensitive to political issues as any ‘banana republic’.

– the problem is that there are two things: risk and uncertainty. Financial markets are built on risk and are confident that they can price it and transfer it. But political issues lead to uncertainty, which no-one knows how to price. There’s a sense in which risk runs along set lines (will the FTSE rise or fall?), whereas uncertainty can come out of the ‘left field’. (As the chair Lutfey Siddiqi, put it, it’s like playing squash in the middle of an earthquake…. ‘Problem with political risk is uncertainty in the range of possible outcomes, not just assigning probabilities amongst them.’) In other words, Knightian uncertainty, which in turn can lead to ambiguity aversion. This is often dealt with by Minimax methods, exploring the nodes of a game tree, which produce an ‘either/or’ investment decision that can exaggerate market swings if the market changes.

– markets are not used to this sort of uncertainty and this may be why VIX is so low despite all the current concerns. (He listed Qatar, Brexit, Syria and N Korea – in that order).Never before has debt been so high, interest rates so low, and the amount of money released by QE so large. No-one knows how to taper QE, or what the effects of winding it down will be. So they ‘wait and see’.

– referring to the complexity of Brexit negotiations, he said that the two year negotiation period under article 50 was designed as a disincentive: anyone contemplating leaving would be put off by the need to get such complex negotiations over in just two years! He forecast that little clarity will emerge until, the eleventh hour.

– one of his major concerns is that the work that has been done to harmonise banking regulations and make the capital markets a safer level playing field may unravel. Incidentally, markets are often unsettled by changes in central bank governors, and Janet Yellen is due to step down at the end of January 2018, with Stanley Fischer due to step down as Deputy in June 2018.

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