‘Cobra effect’ fears means we must listen for the canary

Suddenly, the financial experts seem to be obsessed with risk.

You might think that anybody involved in financial markets should be diligently aware of the factors that might affect global investment trends and economic prospects. The well-being of billions of people depends on their ability to forecast “black swan” events.

But the sheer volume of writing, tweeting and blogging recently about increasing risk in global markets has reached such a volume that you have to sit up and pay attention.

Just a couple of weeks ago, in a symposium in London organised by Citibank, risk was on everybody’s lips. Tina Fordham, the bank’s chief global political analyst, painted quite a gloomy picture of the international scene under the heading “Is this the start of the breakdown?” She was speaking, it should be noted, before the risky situation in Syria deteriorated even further with the intervention of Russia.

What was especially worrying about her talk was the section that focused on financial markets rather than geostrategic risks. Her message was that so far, partly because of continued QE from the Americans and partly because of low energy prices, the markets had not signalled a forthcoming downturn. They were not doing their traditional job of being the “canary in the coal mine”.

About the same time, Nouriel Roubini, the economics guru who has been widely credited with foretelling the crisis in credit and property markets in 2008, wrote of the need for a financial “early warning system” in a world of increased risk and volatility.

“Ratings agencies wait too long to spot risks and downgrade countries, while investors behave like herds, often ignoring the build-up of risk for too long, before shifting gears abruptly and causing exaggerated market swings,” he wrote.

This was particularly alarming. If the man who was effectively the only “early warning system” we had in 2008 (even if largely ignored by policymakers) thinks the need is so great, surely we are in for a tough time ahead. When the canary feels it needs its own canary, you’ve got to worry.

Most of the factors for this new risk awareness are well-documented: increasingly geopolitical uncertainty, especially in the Middle East; a renewal of “great power” rivalry; fears about the Chinese economy; Europe’s migration crisis; the apparently inevitable ending of cheap interest rates by the US Federal Reserve. Those are in the market, as they say.

But just recently a couple of others have surfaced as potentially worrying trends.

A well-argued piece in the Financial Times last week reminded me of the “Cobra effect” by which financial markets will often tend to move in opposite and unintended ways.

In the days of the British Raj in India, the authorities tried to reduce attacks by poisonous snakes by offering a bounty for each dead cobra.

Enterprising villagers began to breed cobras for the reward, causing the powers to scrap the scheme and the villagers to release their deadly crop to the wild. Result: many more snake bites.

The analogy in financial markets is the computer-driven “systematic” investment strategies implemented after the 2009 crisis to minimise risk and enhance returns.

Many financial professionals now believe these systems have played a role in exacerbating volatility and downturns in recently troubled markets. “We are breeding cobras, and now we are releasing them into the wild,” one finance academic was quoted as saying.

The other cause for concern came from the economist Mohamed El Erian, also writing in the FT. He highlighted the significant increase in volatility in the past three months, with the Vix index, the often quoted “fear index”, worryingly high and climbing.

Mr El Erian’s concern was that higher volatility would spook institutional investors, by far the biggest players in global markets, who would be less inclined to play their traditional role as market stabilisers.

One definition of risk is “the intentional interaction with uncertainty,” and of course there is no absolute certainty these risks will actually come to pass. But it’s more important than ever now to listen out for the canary.


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