The S&P 500 Index will probably range between 926 and 1818 at the extremes over the next 260 trading days. The most likely scenario is between 1329 and 1538. The probability of falling towards the left tail doldrums is currently at 0.46. As shown in the accompanying charts/analytics, left tail risks are far more common than is normally assumed. The left tail risks – or emerging events – that could take the S&P 500 Index to the realm of three digits includes two macro-economic/geopolitical events. One of the events, the Euro affair, is prominently in the news. However, how it ends is unknown at this point. The other event is Egypt and its future relations with Israel and Iran. There are impending elections in the middle of June and the ensuing influence on Middle East politics and subsequently on crude oil prices is unknown. The global media has not paid much attention to this event having signed off once Tahrir Square in Cairo cleared of protesters. In addition, US politics is beginning to be a significant source of concern.
These two events are dissimilar in the after-effects they will cause even though they are both significant geopolitical events. If viable solutions for the Euro area are not offered soon, a Greek exit or an exit by any other country such as Portugal, Spain or Italy will be, no doubt, a messy affair. It will be a significant deflationary situation. Indeed, whether it is the strongest member (Germany) or the weakest (Greece) decamping from the Euro is largely irrelevant in effect. The dissolution of the world’s second best currency will shatter global confidence and undoubtedly surpass any other crises since the 1930’s and WW II.
The Euro will have to fall by about 20% from current levels to trade at parity with the US dollar. The Euro is likely to trade at parity with the US dollar over the next 24 to 36 months. How low it drops is subject to semantic quibbles because we do not know all the probabilities in advance. Some improbable actions may become probable overtime. However, the Euro must drop since the European Central Bank, ECB, will be extremely busy trying to provide what is likely to be enormous amounts of liquidity required by European banks in the event of an exit by a Euro country. The Euro’s volatility forward curve (likelihood of up or down overtime) implied by its monthly volatility since inception suggests that it could be at parity with the US dollar within a 12-month period.
International investors will drop the Euro at a much faster rate and flee to other currencies such as the US dollar, Swiss franc, and Singapore dollar. These are already money centers and will likely see an inflow of funds. Because of deflationary concerns, Gold will initially drop but tends to rise to become a “safe haven” – a place to store value – as crises escalate. Indeed, I anticipate that Gold will hit USD 2,000 an ounce over the next 260 trading days as the crisis in Europe escalates – especially if a Euro member exits the club. This is just a 25% run from the current level and, therefore, a much higher price is conceivable if events become uglier.
Virtually all central banks in the world will begin new rounds of monetary easing. Broad equity indices like the S&P 500 Index will undoubtedly track the drop in the Euro. So will commodities and other asset classes. There is no safe haven in a deflationary spiral caused by major sovereign crises (when major currencies and the global financial system are seriously undermined) except perhaps Gold as central banks desperately try to create liquidity in the financial system. US treasuries or German Bunds may rise for a while but these so-called safe havens are now really traps for investors. The US, Japan, and the UK are in no better fiscal position than Europe and are just as vulnerable to rising interest rates and declining bond prices. In time, Germany’s fiscal position is dependent on its neighbors in trouble.
The clear winner will be volatility. If the Euro area can limit the exit to Greece, the S&P 500 Index will likely form the bottom at around 980. If Europe can hold itself together, the S&P 500 Index will actually rebound and likely hit 1650 rather quickly. Most investors know that Europe has been in a general decline since 1980 and lost its share of global output faster than any other region of the world. Investors are looking for signs that Europe has not entered a period of accelerated decline.
Holding Europe together will require the primacy of both politics and markets. European politicians must overcome jingoistic attitudes and seriously seek solutions to address both debt and growth concerns in the region. They must deal with a worrying demographics trend, debt and growth, and deep-seated politics of the masses. Politicians cannot meet their goals of growth, employment, and equity without markets. On the other hand, markets must not push interest rate spreads to extreme values based largely on fear. It will backfire by creating bubbles in other areas such as the US treasuries. The rule of parsimony suggests that there are no safe havens.
Politics and markets always need each other if growth, employment, and equity concerns are to be achieved overtime. The political arena is where extremely difficult questions facing the society (how, why, who, and what of emerging events in public policy) are discussed and broad consensus reached. The markets do a better job of implementing the broad consensus reached by the public. For example, private companies employ more people than governments. They also pay relatively high wages for highly skilled labor. Indeed, politics (that is, human relationships) and economics are actually inseparable.
Unfortunately, combative politics tends to dominate much to the detriment of the majority of the populace in the long-term. This is happening in Greece and Egypt. Their inability to reach broad consensus will not only hurt them but also reverberate throughout the world: Greece through its membership in the Euro and Egypt through its impact on Middle East politics.
These political fights are as old as humanity. Societies must determine how much to produce, what to produce (or even why produce anything in the first place) and, ultimately, who benefits the most or the least from the activities of the society. One might think that these problems would be easy to solve if there were only two people on earth. They could increase their payoff matrix by cooperating and dividing the earth’s resources. Alas, strategic game theory suggests that other options are available. Computer generated results show that non-cooperation is as high as 32%. For the optimist, this is imaginably wrong. It is just computer simulation. However, the Bible offers another insight in the story of Cain and Abel. In the Genesis story – in fact a strategic game theory scenario that should favor cooperation as the overwhelming outcome – Cain surprisingly becomes the first murderer and Abel the first victim.
In summary, we should not overlook the fact that Greece, Egypt and Iran may take actions that will undoubtedly hurt them over the long-term. We may think this is irrational. However, they are just being strategic and tactical even though the payoff can be horrendous in economic terms. After the elections, Egypt is likely to be more confrontational towards Israel yet much more friendly to Iran while Greece may, once again, fail to implement bailout terms thus setting the stage for a Euro exit. Politics in the US could become even more confrontational at the expense of its safe haven status.
Sylvester is a Merchant Banker & Hedge Fund Manager educated in both the United States and Nairobi, Kenya.