Tuesday, January 6, 2015

6/1/2015: Glance Back: Grey and Black Swans of 2014

Portuguese blog by Jorge Nascimento Rodrigues quoting my comments on the topic of black swan and grey swan events of 2014: http://janelanaweb.com/novidades/2014-em-revista-cisnes-negros-cinzentos-6-surpresas/

My comment in English in full:

Black swan events are defined not only by their unpredictability ex ante the shock and the magnitude of the shock-related losses, but also by the fact that the rationale for their occurrence becomes fully explainable ex ante the event. In this sense, looking back at 2014, one can only imperfectly interpret key events as either black or grey swans.

One of the major black swan events of 2014 was the flaring up of a major geopolitical crisis involving Russia and the West. This pre-conditions for the emergence of this crisis were present throughout the late 2000s - early 2010s, but its rapid escalation from to the state of a proxy war fought by the two players over the Ukraine was not something we could have foreseen at the end of 2013.

On economic front, the decoupling of the US economy from global economic outlook and acceleration in the US growth was accurately reflected in a number of major forecasts published in the second half of 2013. As was the associated continued downtrend in growth in the euro area. But the simultaneous crisis across the major emerging economies, including Brazil and South Africa, as well as the onset of the outright recession in Russia and the Russian Ruble crisis of Q4 2014 were black swan events.

A good example of the grey swan event - an event with some predictability ex ante, but with unpredictable timing, was a massive decline in global oil prices. The decline was forecastable in 2013, given the rate of growth in potential supply from the non-OPEC countries, primarily Canada and the US. The rates of new wells drilling and the levels of average output and output dynamics from the existent wells should have told us well in advance that the decline in oil prices was coming. Ditto for the signals coming from the natural gas price divergence in North America against Europe and Asia Pacific. But the exact timing of this decline in oil prices was not easily predictable. In the end, the drop in oil prices in 2014 was driven by a combination of two forces. The supply dynamics - largely predictable, and the contraction in demand driven by the black swan shock to global (and in particular emerging markets) growth.

Two major themes that dominated the financial markets in 2014 - continued decline in sovereign debt yields and simultaneous divergence in prices between the US and European equity markets - was hardly a black swan, given the differences in monetary policies between ECB and the Fed. Nonetheless, to some extent both themes were shaped also by the global growth divergence, and as such, both constitute a sort of a grey swan event.

Last, but not least, the flaring up of the euro area peripheral crisis, starting with Q4 2014 political risk flaring up in Greece, was neither a black swan nor a grey swan, and instead constitutes an empirical regularity of long term instability in the euro area periphery. This instability (both political and economic) is driven by the legacy of the debt crisis and the fallout from the policies used to address it. Nothing, absolutely nothing, has been resolved within the euro area when it comes to addressing debt overhangs present in a number of economies. Nothing has been done to address the endemic lack of structural growth drivers in the majority of the peripheral economies. If anything, the structural growth crisis contagion has now firmly spread to the core economies, such as France and Finland, and is impacting even Germany. Despite lots of sabre-rattling, the ECB remains in a passive policy mode, with the central bank balancesheet stubbornly stuck in the post-crisis lows and liquidity fully captured within a fragmented banking sector.

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