milan swf forum 2 (2)

7/31/2019 Milan SWF Forum 2 (2)

1/41

Keynote Speech

Solving the Long Term

Investment EquationMilan, June 25th 2012

Fabio ScacciavillaniChief Economist, OIF

1
http://www.facebook.com/events/431577316875499/http://www.facebook.com/events/431577316875499/http://www.facebook.com/events/431577316875499/http://www.facebook.com/events/431577316875499/


2/41

Millennial View

2

Western

Europe FSU

United

States Japan China India

1500 17.9% 3.4% 0.3% 3.1% 25.0% 24.5%

1600 20.0 3.5 0.2 2.9 29.1 22.5

1700 22.5 4.4 0.1 4.1 22.3 24.4

1820 23.6 5.4 1.8 3.0 32.9 16.0

1870 33.6 7.6 8.9 2.3 17.2 12.2

1913 33.5 8.6 19.1 2.6 8.9 7.6

1950 26.3 9.6 27.3 3.0 4.5 4.1

1973 25.7 9.4 22.0 7.7 4.6 3.1

1998 20.6 3.4 21.9 7.6 11.5 5.0

2006e 19.0 3.8 19.7 6.3 15.1 6.3

Source: Angus Maddison, The World Economy: A Millennial Perspective, OECD (2001);IMF; Morgan Stanley Research

Contribution to global GDP in the last 6 centuries at 1990 International (PPP) US$


3/41

3


4/41

Shift in Barycenter

4Source: World Bank Global Development Horizons 2011Note: Shares are expressed in real 2005 US dollars


5/41

Economic Barycenter

5


6/41

Gompertz curve

6


7/41

Macrowaves

7


8/41

The Century of the Dragon

8


9/41

Asset Allocation

9


10/41

Mac World vs Tata & HTC

Mature economies retain some advantages

10


11/41

11

How The Extras Became

Protagonists

Most Western countries have been living above their means, thanks to mounting privateliabilities in the US, UK, Spain and public liabilities in Continental Europe

This came as a result of an attempt to counter the loss of technological edge and ademographic decline

Public opinion and leaders in developed world are still in denial

Cuts to discretionary spending, marginal entitlement trimmings and cuts in publicinvestments are mere palliatives

It is required a re-engineering of the fundamental functions of the public sector and itsfinancing starting from the educational system

l d li d


12/41

Secular decline treatedas cyclical problem

12


13/41

Aftermath

The world will deal with the

aftermath of this crisis for several

years.

The illusion of quickly reverting tothe days of easy money and

growing stock indices thanks to

injections of money are giving

way to the awareness that theadjustment will be painful

Some call it the New Normal

13


14/41

Financial Barycenter

The hubs and spikes model of global financialmarkets is inadequate for a multipolar worldand implies a dangerous concentration of

systemic risks Pinnacles: London and New York

Cobweb model is the most natural alternative

South-South relationships need to strengthenand find alternatives linkages

Towards a multi-currency regime

14


15/41

State Capitalism?

15

The crisis of Western liberal

capitalism has coincided with the rise

of a powerful new form of state

capitalism in emerging markets

The crisis of liberal capitalism has

been rendered more serious by the

rise of a potent alternative: state

capitalism which tries to meld thepowers of the state with the powers

of capitalism.

Source : Special Report on State Capitalism


16/41

SWFs: Public vs Private

Historically, the demarcation between public and private sphere in the economy swingslike an irregular pendulum in response to circumstances and political mood.

Financial markets were widely viewed as a preserve of individuals, firms and privateinstitutions

Any interference by a publicly owned entity was deemed an undue interference at oddwith well-established laws, norms and practices.

The massive bail out of key international banks and industries like car manufacturingshattered this sanctimonious attitude.

KfW, EDF, ENI, Fannie & Freddie, Landesbanken etc.

16


17/41

The role of SWFs

The surge in capital flows that we have witnessed overthe last 25 years is the fundamental propeller of this re-balancing because it transformed the sign of thedemographic variable in the equation of economicdevelopment

Qatar vs Russia

The expanding role of SWF reflects this secular inversionin the distribution of global wealth from mature

economies, primarily the United States and Europe, tocountries such as China, India and Brazil which enjoyfavourable demographics, and to those with sizablenatural resources such as the UAE, Norway, Australia andRussia.

17


18/41

Capitalism is Risk

Growth, progress, new ventures, technological advances and implementation of newdiscoveries are subject to uncertainty

Risk will materialize no matter how many precautions one adopts, so a capitalistsystem is inherently subject to instability, cycles, crises and disruptions.

This does not imply that capitalismis wrong. It implies that riskmanagement is atthe core of capitalism and the cornerstone of free markets.

Widespread ineptitude in risk management is more dangerous for free markets thanany collectivist ideology.

Incompetent bankers can obliterate free markets. Communists cant.

18


19/41

When the Crisis Struck

To the majority of practitioners, and almost allregulators, the quasi-meltdown of the

financial markets in the autumn of 2008 cameas a shock

They were genuinely convinced that theywere relying on state-of-the-art models whichwould capture accurately the exposure to riskand provide early signals of impending

mayhem. 19


20/41

Illusion

They were genuinely convinced that fancyformulas and complex numerical solutions topartial differential equations were an accuratedescription of reality.

They were genuinely convinced that they hadreliably estimated, within a narrow confidenceinterval, stable correlations between assetprices, including those of derivatives contracts

20

H d i


21/41

Hedging

21

Everybodythinks he will

be smarterthan the restand be able

to reach foran exit beforethe others


22/41

Financial fragility

22

Unsteady


23/41

Unsteady

Unregulated Markets

1. Asymmetric rewards for success andfailure

2. Marked tendency to herd behavior

3. Ineptitude to monitor at the same timeall sources of risk,

4. Over-reliance on short memory and

recent experience5. Absence of checks and balances in

decision making

23


24/41

The strategies of most

SWFs or FWFs display a

higher risk tolerance onlonger term investments,

with far reaching

implications for their riskmanagement.

24


25/41

SWFs were caught off guard

Many SWFs were run with a degree of sophistication morereminiscent of small family offices rather than leadingfinancial institutions.

They were misled by the microeconomic picture depicted inthe financial analysis of (often unreliable) balance sheetswhich conflicted with the macroeconomic clouds on thehorizon.

Worse, the microeconomic analysis was distorted byaccounting smoke and mirrors that concealed the banksleverage, built through a shadow banking system and theimbalances between short term liabilities and long-termrisky assets that beset Bear Sterns and Lehman and manyother large financial institutions.

25


26/41

Risk Management

26


27/41

We mustlook at

riskunder anew light

27

F k K i h


28/41

Frank Knight

Risk refers to an event whose occurrence

is governed by a probability law and can

be insured against

Uncertainty, refers to an event whose

probability is unknown because, for

example, it is rare (earthquake followed

by tsunami), or it never occurred in the

past (9/11) or because its consequences

are unimaginable (the Lehman default or

an asteroid hitting a large urban area)

28


29/41

Mandelbrot

29

Mandelbrot: even the mostadvanced quantitative methods donot capture the complexity ofphenomena we classify as RISK

Tail Events

Black SwansPersistence

Non Gaussian

Risk Management or


30/41

Risk Management orRain Dance?

The complexity of what we colloquially call risk is extremely varied and, despiteconsiderable research, still poorly understood. Current mathematical knowledge

does not allow measuring the tangle of interactions which give rise to risk.

Financial professionals, at least until the Lehman bankruptcy, believed that risk

was, by and large, measurable via statistical analyses performed on a set of data.

This faith was strengthened by the development of what seemed ever more

sophisticated econometric techniques and asset pricing models. The availability

of massive financial time series on which to test these models seemed to add

soundness to what turned out to be essentially more sophisticated rain dances.

Models are useful in conceptualizing and summarizing intricate phenomena, but

the maze of interrelations among agents, their expectations, their information,

their strategic behaviour and the effect of policy actions escape quantification

30


31/41

Turn off the Autopilot

Risk management is human judgment guided by a set of

imperfect quantitative tools and constantly updated

qualitative assessment. Quantitative tools must not be

considered an auto-pilot system

Asset valuations are probability distributions, not exact

calculations

These probability distributions will always be influenced

by the business cycle, which remains the fundamental

driver of market and systemic risk.

31

M i


32/41

Macroeconomics

Forming expectations on the macroeconomicoutlook is critical but not enough, because the linkbetween macroeconomic fluctuations and assetprices is inherently unstable

Models that aim to estimate the parameters of sucha relationship are not reliable, nor are models thatrely on past data to estimate a probabilitydistribution of returns and correlations

Sloppy currency risk management is financialsuicide in a multi-polar world. FX is a fundamentaldriver of performance

32

A h


33/41

Top Down Approach

33

SWF A Cl


34/41

SWFs as an Asset Class

SWFs rarely face sudden redemptions, hence they donot need to be over-concerned about liquidity risk orcrippling margin calls.

Stable endowment and long-term focus do not imply

complacency on risk management or careless riskassessment.

It means that they need to assign a different set ofweights to various sources of risks than mainstream

asset managers. But the risk management for long term investing is

completely different from the mainstream concept.

34


35/41

Financial returnsdiversification

vs

Growth driversdiversifications

35

Long Run Growth Drivers and


36/41

Long Run Growth Drivers and

Implications for Risk Management

36

What drives long term growth? => Investment Themesrather than asset classes in order to diversify risk.

Demographics & Education

Infrastructure & Urbanization

Natural Resources Supercycle

Technological Advances

Logistics and integration of value chains

Fluidification of Business Environment

The Six Killer Applications (Niall Ferguson)


37/41

Six Killer Applications

Political and economic competition

Rule of law

Scientific revolution

Modern medicine

Education

The work ethic

37

Institutional

Capital

Human

Capital


38/41

Hi-Tech

The most difficult strategies for risk managementare those that pursue technological advances.Here the only meaningful approach is a

diversification into several projects.

Betting on new technologies requires a hugetolerance for failure, because in the bestcircumstances only half of the projects survive andeven fewer thrive.

38

Di d i h di


39/41

Diamond in the dirt

At the far end of the risk spectrum are investmentsthat aim to take advantage of a return to normalcy inwar-stricken countries. This driver is largelyindependent of global macroeconomic conditions,but needless to say, the success of investments inplaces like Iraq or Ivory Coast is a bet that spans atleast 510 years.

Few dare to invest in such places but to skeptics it

suffices to mention that Lebanon has been one of thebest performing economies throughout the GreatRecession and that the Iraqi stock market was astellar performer in 20102011.

39

Concluding Remarks


40/41

Concluding Remarks

40

Risk management hinging on financial time series is misleading

Many prescriptions to manage risk which might be sensible at

microeconomic levelMarkets sometimes do not work properly: if they were therewould be no need for prudential supervision

Insisting on market mechanisms to solve problem arising fromdysfunctional markets is a recipe for disaster

Long term risk management needs to focus on long term driversof growth.


41/41

Thank YouOman Investment Fund (OIF)

P. O. Box 329, P.C. 115Sultanate of Oman

T: +968-2464 3035

M: +968-9321 4978

F: +968-2469 1344

E: [email protected]

W: http://www.oif.om
mailto:[email protected]://www.oif.om/http://www.oif.om/mailto:[email protected]

milan swf forum 2 (2)

Documents