In one of Rembrandt’s famous paintings, Storm on the Sea of Galilee, a ship’s crew struggles to navigate through an epic storm thrashing the ship. But toward the stern, Jesus sits calmly. This image graced the cover of Peter Bernstein’s classic book, Against the Gods: The Remarkable Story of Risk. So what can investors take away from a classic piece of Renaissance art? Market shocks can emerge suddenly and in unexpected ways. Mitigating the impact of these risks is no doubt challenging when they are difficult to predict. Still, investors need a gameplan.
This episode of PGIM’s The OUTThinking Investor delivers fresh perspectives on potential risks to financial markets and explores strategies that agile investors can employ to protect their portfolios against the known and unknown. Joining us to discuss this topic are Scott Patterson, Wall Street Journal reporter and author of Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis; Ethan Wu, Financial Times reporter and host of the Unhedged podcast; and Michael Dicks, Chief Economist and Deputy Head of Research at PGIM Wadhwani.
>> In 1633, Rembrandt unveiled his only seascape painting, which was also one of his most influential masterpieces. Rembrandt's famous Storm on the Sea of Galilee depicts a crew battling against an epic storm and trying to save their ship. A monstrous wave carries the ship out of the water. The main sail is torn in half. You can feel the sheer distress of the crew, all except for one. Toward the stern of the ship, Jesus sits calmly with his gaze on the crew and his hands in prayer. This masterpiece is well-known to admirers of Renaissance art. Investors might also recognize it as the cover image of Peter Bernstein's classic book, Against the Gods: The Remarkable Story of Risk. The concept of investment risk doesn't naturally evoke images of Renaissance art, but the title of the book says it all. Not only is the history of risk an epic story, but extreme risk events often feel like divine intervention. Investors who think about extreme risk are preparing to deal with the unexpected and to make decisions in the face of uncertainty. How we view risk is crucial to how we manage it. Like Jesus in Rembrandt's painting, we have a choice. We can spend our energy battling elements beyond our control, or we can focus on the things within our influence. For extreme investment risk, including market shocks, can we better prepare for the upside and the downside? Will big data and machine learning improve our forecasts of extreme risk, or do we need to change the way we view risk? To understand today's investment landscape, it's important to know how we got here. This is The OUTThinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. In this episode, three experts share their views on predicting market shocks and managing portfolio risk. Mike Dicks is Chief Economist and Deputy Head of Research for PGIM Wadhwani, a boutique within PGIM. Scott Patterson is a reporter for The Wall Street Journal and the author of Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis. And Ethan Wu is a reporter at the Financial Times and host of the Financial Times podcast, Unhedged. Risk boils down to the fact that more things can happen than actually will happen. That includes good things, too. Over the past several years, the number and magnitude of extreme risk events have left investors questioning traditional approaches to managing portfolio risk such as the 60/40 stock-bond portfolio. Ethan Wu explains the fallout.
>> The surge in inflation we've seen since the pandemic, I think what critically it's done for the 60/40 portfolio is it scrambled that relationship between stocks and bonds. In 22, we had both a brutal year for stocks and one of the worst years for bonds in decades, by some measure, centuries. And the question now is, "Is that a structural shift? Or did we see some kind of post-pandemic anomaly, you know, analogous to what we saw after the Second World War where you shut down the economy, you reopen it, and it takes time to reallocate activity between different sectors of the economy?" If you have a stable and consistent 3% inflation rate, bonds can adjust to that equilibrium. But if you have an inflation rate that gyrates between 2% and 4% on an unpredictable basis, that's something that could be a real long-term structural challenge for a 60/40 allocation. And I think it's just not clear yet if that's the world we're heading to.
>> The power of diversification that investors rely on to protect against downside risk from inflation or any other factor often breaks down when they need it most, that is, when volatility surges. Here's Scott Patterson.
>> In times of chaos, the historical correlations don't always work the way they're supposed to. The leveraging just destroys every correlation you can imagine. We saw that in 2007 and 2008. They can work okay in normal times. It's the -- you know, chaotic crashes where they don't. Everything just sort of falls apart. And if you're leveraged into that, then you have a real big problem.
>> Global financial markets have experienced several Six Sigma events over the past several decades, which seems outsized according to the very definition of a Six Sigma event. Are we looking at risk and uncertainty through the wrong lens? PGIM's Mike Dicks believes so.
>> You must be using the sort of wrong model if you think it's Six Sigma. So that sort of means whatever tool is being used to predict, you know, those left tail events is not very good at forecasting if the true incidence is turning out to be bigger, and when they happen, they're even bigger than you expected. So I do think there are some sort of technical things you can do to improve your model set, if you like. So a narrow one is assume the distribution has got much fatter tails, especially on the left hand side. But I think the much bigger thing is actually to ask yourself again to think outside the box, and say, "You know, perhaps, when you're looking at past data, you're making an assumption that the futures like that data." But you need to take another step, and say, for example, "Are there multiple regimes or different environments that we've seen in the past during which you need different sorts of tools to correctly measure the likelihood of those left tail events?" We've been doing quite a lot of work where we put much more weight on the 1970s because that was the period where we saw inflation really destroying people's portfolios, having big impacts. So you don't necessarily have to throw away but you put much less weight on that period since the 70s when we haven't been in a high inflation environment. And once you start doing that, some of those Six Sigma events come back and turn out to be twos or threes. So you're still getting shocks, but not anything like on the scale, or as often as when you've, like incorrectly assumed a future is just like the past.
>> Scott Patterson shares another well-known view.
>> This has been something that Nassim Taleb has been banging on about for decades is that the traditional metrics that Wall Street has been using for quite some time -- basically, just, they ignore the Six Sigma event, which Six Sigma, it's something that, like, would happen in, you know, three universes. It's, you know, something that just shouldn't happen. And when you say what we've seen multiple Six Sigma events in past couple decades, then you sort of know there's something wrong with that way of looking at risk. So what you find is you look at various risk management metrics like value at risk, value at risk used by all the major banks. It looks at the volatility in the bank's portfolio 95% of the time. So for whatever reason, they decided to cut out 5% of the volatility. And the reason for that is, it scrambles the math. You're basically carving out the most important part of the equation, is the thing that can blow you up because it's more convenient to the models. The biggest problem, I think, with these things is they lead to this false sense of security that you've got your risk managed. It's the Black Swan, people don't want to think about the Black Swan because it's inconvenient. But it's also, really, at the end of the day, the thing that you need to worry about the most.
>> However, no two investors are the same. Institutional investors have different demands, different challenges, different goals. That matters quite a lot, and especially when it comes to investing in less liquid assets like alternatives.
>> Some are going to be willing and able to lock themselves up in funds that don't have a lot of short-term drawdown potential, and that's going to be okay. And that's going to be a source of return for that institutional investor that might not be available to an investor that has regular redemptions they need to continuously meet. And we've seen more, and more funds pushing in that direction, ones that have longer-term outlooks, moving into more illiquid stuff. But some people think that this could create a broader structural risk for financial markets. That obviously remains to be seen. But if you're an investor that understands your own liability structure, and you can stress test your portfolio, it can be a source of additional returns for you that might not be available to everyone else.
>> It takes a full toolkit to consistently achieve investment targets over the long term. But adding opportunities can also increase complexity and downside potential. What are some of the more interesting ways of managing risk?
>> I think things like machine learning allow us to process quickly lots more data. We're finding that we're able to speed up some of our reaction times. So even in some of the more conventional models where we might be looking at daily data, you're looking back 100 days, we find it's much better if you can to get intraday data and update your estimates with a much shorter look back period. So for example, on something like the bond equity correlation, which can shift, and what you thought was a hedge turn out to make things an awful lot worse for you. If they see that switch, and you can imagine the switch is often driven by say, inflation risks, those sorts of things, we now have tools where we're updating every 15 minutes and consequently picking up shifts in the correlation within a day or two as opposed to within weeks or even a month or two. So that's made us much more agile.
>> Fortunately, interesting doesn't always mean overcomplicated.
>> I think a really underrated way is sitting in cash, or in one-year treasuries, or something that has a guaranteed source of returns, especially in an environment, when it's not clear what the macro outlook is going to be. And investing on the basis that you know what the macro outlook is, I think, there's a value in humility at a moment like this. And a humility trade is buying one year treasuries and holding it to maturity, taking your 5% guaranteed yield. And you know, maybe you don't massively outperform the market. But if there is an energy shock, if there is a regime shift you're unprepared for, you're in a decent position. I think especially for more conservative institutional investors, a lot of the job is to protect your downside. The upside takes care of itself if you've protected your downside. For some investors, there are these more boutique tail risk protection options available from a variety of funds on the market. And you know, these have the basic tradeoff of buying heavily out of the money put options where you're paying a little premium, paying, paying, paying, paying, and then if the market suddenly crashes, then your tail risk edge is way, way up and you've protected your downside. This is something that might be harder for a smaller institutional investor to finance because those premium payments are going to cut into returns year after year. And there's a question of, you know, "Is this regular premium payment something I can afford, something that's going to cut into my -- into my returns over the long run?" But for some investors with greater financial heft especially, those kind of options can also present another way to mitigate risk.
>> How the investor views risk can also influence the way they manage risk, and whether that's a particularly broad or narrow perspective and portfolio approach.
>> Thinking about volatility is only hurting you if it happens to be that you're in drawdown mode. You know, that's when volatility is potentially a killer. If you get volatility in a world where you're making money, you probably don't care very much about it. So a very simple way for asset managers to compare and contrast, you know, various portfolios out there, is to just ask for that data to show whether or not the Sortino ratio is -- typically, if you're lucky, you can get one and a half to two times your Sharpe ratio on a Sortino ratio, and you're doing well in managing that risk. But get those data and compare the various portfolios or asset managers. And that tells you a lot about the smoothness of the ride, if you like, investors' point of view.
>> While the Sortino ratio is not as common as the Sharpe ratio or the information ratio, it is quite useful in focusing solely on downside risk, which is what keeps investors up at night. That also depends in part on the investor's time horizon. Looking out over the next year or so, there are a few things keeping Mike Dicks up at night.
>> I think the fact that we've had better than expected macro data in the US, if you like, hopes that there was resilience in the face of tightening that then would lead to a soft landing. I think that's potentially left investors complacent in assuming that somehow this time is different. So I worry that next year, we may see the US nevertheless ending up in recession, and it feeling a lot worse because you'd hoped that you'd avoided it. I think here in Europe, you know, it may be happening even quicker. But if it's a global story, you know, that's quite a big risk, if you like, that may not be built into people's expectations. The second thing I think we've been, if you like, pleasantly surprised by this year, is how when we've had a credit event like SVB, the impacts of that have, again, turned out thus far to be lower than most people expected.
>> Concern about potential aftershocks from SVB or Silicon Valley Bank seems to have dwindled since earlier this year. Trying to identify the next big risk might feel a bit like whack-a-mole.
>> If you'd look, for example, at those senior loan officer surveys, you would have said, "Oh, recession straight away." We obviously haven't seen that. We've seen strong growth. And I think more generally, when you get the sort of tightening that we've seen globally, this past year or so, you usually see sovereign events, you know, real important credit events. And I worry there's a complacency that's crept in there, assuming that somehow the world is much better run. When I actually look at the detail, I could pick specific countries. I think it's not a lot better run. In some ways, it's worse run than it used to be. And I think of vulnerabilities and how that potentially could play out. And then the third one, and I guess is always something you worry about but it feels to me more important in this next year or so than it has been for a while, is called geopolitical risks. So that could be in the US when we've obviously seen in the past presidential elections turn out to represent much greater risks than you would have expected. On top of that, what that means for foreign policy, there were to be a change both in Russia, Ukraine, and perhaps, more importantly in China. But both of those are potentially massively important for the global economy and then what that may mean for financial markets. So those are the sorts of things pretty hard to predict, but does require you to be incredibly agile in case it pans out in a very negative way.
>> Perhaps, focusing on agility and other adaptive techniques is more effective than trying to identify the next big risks.
>> The Black Swan view of the world is you never know what the risk is. And it's not what you think it is. It's going to come out of nowhere and whack you upside the head. And after you pick yourself up and dust yourself off, you look back and say, "Oh, well, I saw that coming all along." So you know, that's hindsight bias. But we're seeing some pretty scary stuff out of the Chinese economy now with the meltdown of this commercial property company. And that's just a symptom of broader issues that are plaguing Chinese economy. Now, I have been predicting a meltdown in the Chinese economy due to the high levels of debt since around 2002. So I would say my ability to predict China is limited to the extreme because, surprisingly, the government, every time something happens, they just move in and they bail things out. That's just been the model. We've seen it over, and over again in the banking system. So we'll see. You'd think eventually that's not going to work. I think the difference now from previous periods of volatility in the Chinese economy is that it's not growing at the 10% or so rate that it had been that I think that allowed them to grow out of some of the problems. Now, it's a lot slower. That could be a new factor that makes it more difficult for them to pull out of it. Now, the plus side for China, they dominate climate technology in a shocking manner. They're the biggest producers of solar, wind, turbines, and other technology with wind. Eighty to 90% of all of the chemicals that go into lithium ion batteries that power RVs and EVs and other things are processed in China. The other thing, obviously, is interest rate in the US. It's hard to see how that doesn't create some unknown ripple effects after such a long period of virtually zero rates. You have a whole generation of traders on Wall Street now who never saw a T bond rate higher than 2%. And that's just, I think, created a, you know, sort of mentality for -- you know, rates don't go up and that has to just eventually create some systemic event in financial markets. So these things just sort of ripple through the financial system. We're really just seeing the beginning of it. It's not going to slow down.
>> It's impossible to forecast extreme risks accurately, but if near-perfect foresight were possible, it's difficult to know how to position a portfolio for specific risks. We rarely, if ever, have the luxury of facing one risk at a time. The world is dynamic and risks can be cumulative or even countervailing.
>> One way that you can deal with, if you like, unknown unknowns is to ensure that agility is actually built in. So whatever happens, whichever scenario plays out, you're quick to react to the fact that you've identified a new regime or a new environment. The second thing is if you know there's an upcoming event, so like an election, you should probably reduce risk ahead of time. That's the sort of thing we do formalize, and we can sometimes get useful data from betting markets or maybe polling data, you know, that help you ascertain in advance, put some probabilities on the different scenarios, if you like. So that has proven to be quite helpful to us around events like Brexit, where we knew the date. But if they really are from left field, that's where the agility bit is key, because you need to be able to react really quickly, ideally within the day.
>> The unknown unknowns are always the scariest, but perhaps, we can take a note from Rembrandt's famous painting. Focus on those thoughts, actions, and reactions that are within our control and aim for the self-discipline to not be distracted by the rest. While it sounds simple, this will always be subjective and situational. Case in point. In March of 1990, Rembrandt's famous seascape painting was stolen from a gallery, along with a dozen others. The thieves were dressed as police officers and managed to pull off the largest art theft in US history. It remains unsolved to this day. So it seems that even with the most extreme risks, someone is likely willing to take a chance, depending on the potential upside. Thanks to our experts, Mike Dicks, Ethan Wu, and Scott Patterson for their insights on how to think about and prepare for extreme risk. The OUTThinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.
>> This podcast is intended solely for professional investor use. Past performance is not a guarantee of future results. All investments involve risk, including the loss of capital. PGIM is not acting as your fiduciary. The contents are for informational purposes only, are based on information available when created, and are subject to change. It is not intended as investment, legal, or tax advice, and does not consider a recipient's financial objectives. This podcast includes the views and opinions of the authors and may not reflect PGIM's views. PGIM and its related entities may make investment decisions that are inconsistent with the views expressed herein. This podcast should not be reproduced without PGIM's prior written consent. No liability is accepted for any direct, indirect, or consequential loss that may arise from any use of the information contained in or derived from this podcast. This material is not for distribution to any recipient located in any jurisdiction where such distribution is unlawful. PGIM is the global asset management business of Prudential Financial Inc., which is not affiliated in any manner with Prudential PLC, incorporated in the United Kingdom, or with Prudential Assurance Company, a subsidiary of M&G PLC, incorporated in the United Kingdom. Copyright, 2023. The PGIM logo and the rock symbol are service marks of PGIM's and its related entities registered in many jurisdictions worldwide.