If the 21st century has taught us anything, it is that extraordinary things happen. The new edition of Towers Watson’s Extreme Risks report details 15 whoppers. Not surprisingly, given the global consulting firm’s excellent reputation, the report is written in measured, conservative language. Still, it is a fascinating read.
The risks are measured in terms of impact and likelihood. Those judged most likely, relative to the others, are a banking crisis, depression, currency crisis, a breakup of the eurozone (in which at least one member country exits) and protectionism (as in a reversal of free trade). In the firm’s opinion, a depression would have a high impact. A currency crisis and euro breakup would have a medium impact. And a rise in protectionism would have a low impact.
I spoke with Janet Rabovsky, director, investment consulting at Towers Watson about the report. Here’s a condensed Q&A.
What’s the purpose of this report?
Our working premise is that we think bad things are going to continue to happen more and more frequently. We think there’s going to be some sort of major event every few years. And that’s simply because there’s such an interconnectedness now of economies and markets. For example, we identified the breakup of the euro a few years ago. It was something that we thought had a low probability at the time, but could obviously have disastrous results. That’s gone up in our ranking as there is a real possibility.
How concerned are you about a sovereign default?
We actually think it could happen. The world is working very closely – the International Monetary Fund, the European Financial Stability Facility, all the different groups – to try and prevent a default. Technically, Greece is pretty much insolvent. But that issue is relatively small. What everybody’s concerned about right now is Italy. There’s nobody that could absorb that. For those countries that default, the cost of borrowing increases. We’ve already seen that with the cost of French debt and Italian debt. And then there’s a lack of support among investors. It’s almost like a self-fulfilling prophecy. If a major country like Italy defaulted, that’s a big problem. There’s no ability for the current financial system to absorb that default.
What kind of effect would a euro breakup cause?
It would have a massive impact. But I think it’s somewhat calibrated because we don’t think it’s going to happen in the near-term. If you look at the amount of time, money and effort invested by Germany and France; everybody wants to try and make this work. There may be a way that Greece exits in an orderly fashion in the next few years, but nobody else is going to at this point.
Megan Greene of Roubini Global Economics, who has predicted a eurozone breakup, said the impact on the global financial system would be a “Lehman-times-five event.” Do you agree?
I can’t calibrate it, but that seems reasonable. There’s so much interconnectedness. You’ve got people holding European debt, people holding European equities. All the contracts, all the businesses; think about all the work that went into getting them to the euro. Exiting would be a nightmare.
A banking crisis is more likely now than it was in your 2009 report, which you link to a slow economic recovery.
Europe is teetering on the edge of recession again, if it’s not already in recession. Certainly the U.S. is coming out, but it’s slow. And interest rates in North America and in Europe remain artificially low. So what you have then is an impingement on the banks’ ability to make money. Banks make money by lending money out. Their cost is paying the depositors that they’re borrowing from. Right now, there’s not enough spread for them. They need higher rates and bigger margins. Their earnings have compressed. Now, think about all the changes to traditional banking and investment banking. They can no longer subsidize this business with their investment banking earnings because of the financial turmoil and because they’re precluded from doing certain things. The other reason that their balance sheets are impacted is that they own a lot of U.S. and European real estate that they don’t want to own. In Europe specifically, a lot of the banks were given attractive incentives to buy European debt which takes us back to the euro issue again. Now that debt’s not worth 100 cents on the dollar. So it’s a bit of a mess.
What are the key messages here for Canadian investors?
We think that there are going to be market-turmoil events that will occur every few years. As an investor, you need to decide whether you are constructing your investment portfolio for what you expect or for the worst-case outcome. Thinking about risk tolerance, time horizon and cash flow is really important. Do you have a stable job? Could you up your contributions? What stage of life are you in? If you are on contract as opposed to in a full-time job or if you have just a few years until retirement, you may want to have a less risky portfolio to mitigate some of these things that could potentially happen. It’s up to the individual to assess how they want to construct their portfolio. We are definitely going to have more of these events. I think being more aware; understanding what the influences are and what happens if things don’t go as you planned is important. Maybe save more and be less risky. We’re certainly telling our pension funds that. Accept a higher cost for greater certainty. Take out some of the volatility. Don’t be so reliant on equities. Equity volatility – you’re going to get there, but it’s going to be a heck of a ride.
How money-savvy are you?
Will your choices help you reach your financial goals?
Try our Financial habits quiz.