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  • Writer's pictureTikona Capital

Markets headed - Risk or Uncertainty?

Updated: Sep 25, 2023

In comparison to worldwide markets, the NIFTY has corrected by 18% from its yearly high. NASDAQ by ~35%, HANGSENG by ~34%, KOSPI by ~30%, and EURO STOXX by ~26% from their respective yearly highs. However, it is worth noting that, while most markets are trading lower than the lows recorded in June 2022, India is surprisingly 10% higher. While India remains connected with global markets, we have begun to go down the path of decoupling (our article on August 1, 2022, Is India on Path of Decoupling?, much before it became the buzz of the town).

The rise in inflation, which began due to QE during COVID-19 and was later fueled by supply chain concerns and then by geopolitical issues, has boiled into a heightened increase in interest rates. Quicker and larger blocks of increases in interest rates have overblown currency volatility. Is such an environment an uncertainty or unknown - unknown risk?

Let's get a better understanding of it! Uncertainty is defined as a lack of absolute assurance. The result of any event is completely unknown in uncertainty, and it cannot be quantified or inferred; you have no background knowledge about the event. Uncertainty is not an unknown risk. In an environment of uncertainty, you completely lack the background information of an event, even though it has been identified. In the case of unknown risk, although one has the background information, one does not include it in their assumptions throughout the identification process.

Risk management is built on the manager's capacity to identify, value, and then minimize the appropriate risks. Different people use various frameworks. Donald Rumsfeld, the United States Secretary of Defense amid the subprime mortgage crisis, popularised one such framework. This framework classifies risks based on knowns and unknowns.

The known-unknown framework assists in categorizing risks based on our understanding of them. This framework is unique in the sense that it acknowledges that there are some risks that we cannot find out about, no matter how diligent we are. After the 2008 crisis, this matrix has been used frequently to classify risks into four distinct categories.

  1. Known Risks: When it comes to risk management, known knowns are the simplest sort of risk. The likelihood of their occurrence as well as their influence is known. Mathematical models may be created to assist in making decisions that consider the price of the effects of such risks. For example, because equities are a riskier asset class than government bonds, we construct an equity risk premium over a risk-free interest rate.

  2. Known Unknown Risks: One is aware of the presence of such a risk; nevertheless, one is unaware of the likelihood that this risk will impact them. At the same time, they are unable to estimate the consequences of these risks if they occur. While it is well known that equity prices are volatile, in a bearish market, investors use hedging to limit the loss to their portfolio. Similarly, taking out insurance if the risk is known but not the timing or magnitude of the risk.

  3. Unknown Known Risks: These are risks that arise because of negligence or ignoring a known risk. It is imprudent to assume that an adverse outcome will never occur, and such risks are rarely acknowledged in the risk management framework. Injecting liquidity (read Quantitative Easing) would, for example, feed inflation, which is a well-known phenomenon. Low inflation (post-GFC to pre-covid period), however, caused central banks in the developed countries to ignore this premise and inject massive sums of cash to boost the economy post covid. This injection of liquidity is now causing uncontrollable inflation.

  4. Unknown-Unknown Risks: These are the most dangerous forms of risks, which cause markets to be knee-jerk. One unknown represents the fact that the investor is unaware that such a risk exists. As a result, the issue of assessing and quantifying risk does not truly emerge. These risks often have a substantial impact and threaten the very existence of the entity. No matter how hard the risk managers tried, they would have found it difficult to accurately foresee the existence and impact of this sort of risk. All mathematical risk management models begin to fail at this point. These occurrences have been dubbed "Black Swan incidents." For example, in the COVID crisis, neither the presence of the event nor the degree of its influence could be determined, resulting in such a correction.

As previously stated, under uncertainty, the outcome of any event is completely unknown and cannot be quantified or predicted; you have no background knowledge about the occurrence. For example, a world war, a political fallout, or a natural calamity. Where an occurrence would send an investor into a tailspin and cause them to exit the market.

High inflation, and rising interest rates have created unexpected currency volatility and an unknown impact of volatility - an unknown-unknown risk but not “an uncertain” environment.

Inflation peaking? We know that crude has fallen from a high of $120/barrel to less than $90/barrel in the last three months, the Bloomberg commodity index has fallen from a high of 137 to 113 in the last three months, and container freight on key routes has fallen to last year's levels; all of this points to inflation peaking and then falling in the next 3-6 months.

Interest rate peaking? While the US fed funds rates are expected to rise to ~4.75%-5.0% levels; domestically RBI is expected to hike 50 basis points in September, and further hikes in upcoming meetings, taking the terminal repo rate to 6.5%. Key to watching will be the commentary on when they expect the inflation to peak out and thereby the reversal of the interest rate cycle. Most bankers may continue to sound hawkish to reverse the inflation trajectory at a faster pace.

Systemic Risk? The key will be to ensure that system stability is not jeopardised by volatility in currency and the largest risk-free asset class-government bonds owned by large institutions. At the time of drafting this article, the Bank of England had already taken the step of purchasing bonds to protect the stability of pension funds.

What to do?

We believe that we are in an unknown-risk scenario rather than in an uncertain environment. While the markets would transition from unknown currency volatility and the unknown impact of volatility (unknown - unknown) to bond/currency volatility management to restrict the impact (known - unknown) and thereafter peaking of the inflation-interest rate (known-known), Such an unfolding of events would be a goldilocks moment for India as India's debt to GDP ratio is far superior to most countries in the world since India resorted to targeted stimulus programs vs. most countries using a helicopter money approach. India is a blooming oasis full of sparkling and thirst-quenching water in a vast desert of countries saddled with high debt, rising inflation, and the policymaker's inefficient legacy approach to throwing money at every crisis! India has multiple drivers of growth - PLI Schemes, global scalability, technology-ready talent, a vibrant startup/entrepreneurial ecosystem, capable government leadership, and the availability of risk capital to fuel the next leg of the multi-year bull market. As we may call it, the AMRIT KAAL.

In the current scenario, we are optimistic about and prefer the Consumerism, Formalization, and Financialization themes among the six multidecadal themes highlighted on our website,

Stay healthy! Stay Invested! Strengthen your portfolio during such times!

Sumit Poddar

Chief Investment Officer & Smallcase Portfolio Manager

Tikona Capital

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