CFM Talks To: Robert Engle

15 November 2019

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We had the privilege of sitting down with Professor Robert Engle at his New York University office to discuss a range of contemporary topics, as well as some of his current research interests. Rob is currently the Michael Armellino Professor of Management and Financial Services, as well as Director of the Volatility Institute at the Leonard N. Stern School of Business. He is perhaps best known for his work on volatility modelling, for which, along with Clive Granger, he was awarded the Nobel Memorial Prize in Economics in 2003. His work has found wide application in the economics and finance professions, in particular the techniques he developed for more accurate risk forecasting.

Rob remains active and involved in the public discourse on economic and trade policy, as well as systemic risk. He also continues to teach, amongst others, in the NYU Stern MBA program. We asked Rob about his opinion around a set of three key themes: global economic uncertainty and geopolitical risk, his views on the US economy and current policy, as well as his new-fangled interest in climate change and risk. We also took the opportunity to get his take on some of the most talked about trends in asset management.

Robert Engle fade with quote for website

CFM:    

It might be appropriate to kick off with geopolitical risk, given that over the weekend (14 September) an attack on a Saudi Arabian oil refinery sent oil prices rallying and incited a surge in market volatility. This new threat – an apparent susceptibility of Saudi oil infrastructure – adds to an already long list of geopolitical risks. To what extent do you think markets are accurately pricing risk, and how might it be hedged?

RE:    

In reading the literature on geopolitical risk you see lots of different ideas as to what it really is. And, clearly, when any portfolio underperforms, a ready answer is geopolitical risk. I have taken the view that by geopolitical risk, we mean geopolitical events that move markets.

We know that volatilities are to some extent predictable, and, if you investigate the history of volatilities of different countries and different asset classes, they typically peak at the same time. It then follows that volatility innovation is probably common across countries and asset classes. The drone strike on the Saudi refinery was completely unpredictable and affected all asset classes around the globe – not just commodities. And, as such, one can argue it was an innovation sprung from a geopolitical risk.

I have developed a statistical approach to assess how sensitive different countries and asset classes are to such a ‘common shock’. If a shock really is ‘common’ to all asset classes, every portfolio should be subject to the same shock. So, whilst there might be a ‘geopolitical risk premium’, one is still unable to predict when it’s going to happen, and whether it will affect all asset classes. It turns out there is evidence that certain countries and asset classes are more sensitive to these common shocks than others.

And is it possible to hedge it?

An optimal portfolio – a Markowitz mean-variance-like portfolio for instance – is desirable because it features low volatility. But, what you would really like to know is that the volatility will stay low. So, if your preference is for a portfolio to be relatively unexposed to geopolitical risks, it is a different criteria, where a Markowitz portfolio might not be optimal. You might want to deviate from the Markowitz portfolio, or have another measure for optimisation other than just mean-variance efficiency – that is if you believe there to be a paradigm of heightened geopolitical risks.

CFM:    

Following this chain of reasoning, one could argue, despite much punditry, that pinpointing a particular theme or type of geopolitical risk and how that might manifest in the markets is irrelevant? Is it how the common shock affects global market that matters?

RE:    

Yes indeed. I can go back in time and identify the days where we observed the most volatility owing to a ‘geopolitical risk’: 9/11, or, the day right after the Brexit vote. These are clearly two totally different events – one a terrorist attack, the other part of a political process.

CFM:    

Have you observed any geopolitical risks that produce unique persistence in volatility?

RE:    

Geopolitical risks are themselves supposed to be innovations, and as such do not have any autocorrelation. The shock itself predicts an increase in volatility, for instance following some sort of a GARCH-model. (Readers can refer to the appendix in our whitepaper entitled ‘Of Presidents and Heart Attacks – risk control as diversification through time’ for a dummy’s guide to GARCH-models.) One observes the consequences of the shock persisting for some substantial amount of time, but the shocks themselves should be serially uncorrelated. At the same time they should be clustered and you’ll find, taking a good example, more of these shocks during the 2007-2008 financial crisis.

CFM:    

Robert Shiller, for one, has been arguing that the growing narrative of recession, is likely to be causative of a recession. Do you believe it likely that the more frequent geopolitical shocks are supporting the fear of a recession?

RE:    

Specific to my framework, a recession that gradually materialises wouldn’t trigger any heightened volatility risk, since there is no particular moment where the system is being shocked. Nonetheless, one of the geopolitical events that shows up in our metric was on 22 January 2008 – the day the Fed lowered interest rates 75 basis points without having a meeting. One thinks of this as an economic event, but the rate cut conveyed meaningful information about how serious the Fed thought the financial crisis was going to be – ultimately producing lots of volatility in financial markets all around the world.

CFM:    

Your last comment is an appropriate segue into the topic of monetary policy – a theme that is garnering immense scrutiny amidst a cacophony of conflicting voices on the appropriate monetary policy path. Tomorrow (18 September) the Fed will in all likelihood cut interest rates a further 25 basis points. Do you think this is the right decision?

RE:    

It depends on what they see in the Beige book. I suspect they are seeing stress in various areas, and have to balance what markets are expecting. But, I have to say, we have become too focused on the stock market as a way of measuring the performance of the economy. And the stock market is going up for a variety of other reasons – buybacks mostly, because of the big tax cut.

Based on what I observe, I am not sure I would lower rates. But I also think once we are at 2%, there is not much juice left in monetary stimulus. I would, however, certainly caution against negative interest rates.

CFM:    

Your assessment rhymes with those of many others who question the efficacy of further monetary policy easing – especially as a remedial action to market externalities. In a run-up event to the G7 held in France earlier this year, François Villeroy de Galhau, Governor of the Banque de France, said that “monetary policy cannot repair the damage caused by protectionist uncertainties.” Would you wager that the path of looser monetary policy is, in large part, a response to current trade uncertainties?

RE:    

Yes. I think the US trade policy has hurt global growth, but, in particular, has hurt the US economy. And if you believe the economy is vulnerable to further downside risks, a monetary or fiscal policy response is typically called upon. But, invariably, one first turns to monetary policy as it is more flexible, and, the US has probably exhausted what it could achieve with fiscal policy via the tax cut. And, so, there is a call upon monetary policy because there aren’t many other options.

CFM:    

Do you share the ECB, and its outgoing president Mario Draghi’s view that fiscal policy, in the event of any further economic deterioration, should “assume a more prominent role in sustaining demand.” 11

RE:    

I have spoken very disapprovingly about the austerity measures and rhetoric that have dominated European policy discussions. However, when I am asked about the US, I say there was a period – a very short amount of time ago – when the Tea Party was pushing for no debt, no tax increases – the small government idea. That has been turned upside down with the tax cut and the enormous growth in the deficit. I am not convinced the US economy, given that it has been engaged in substantial fiscal stimulus, needs monetary policy easing in addition. To me, the evidence is not that conclusive that fiscal stimulus has been effective in the US, except for propelling the stock market.

CFM:    

Along with the discussion of monetary policy, is the fear amongst some that the cycle of cheap money is driving the growth of outstanding credit to risky levels. Are you monitoring the amount of credit swirling around in markets?

RE:    

What I monitor is whether banks in the US, and roughly 70 other countries, seem to have enough capital given their outstanding debt, and the market value of their equity. This is akin to a stress-test and it is a measure we call ‘SRISK’12. This is a measure of the amount of dollars a bank would need to raise in order to continue to function normally, if there is another financial shock like the 2007-2008 financial crisis, when the stock market fell by 40% over six months.

What we observe from this measure is that China and Japan feature as the two countries with the highest shortfall – and going up, but slowly. The US’ shortfall, however, is low, but going up rapidly. The sum of the global shortfall is, alarmingly, as high as it was during the financial crisis - approximately $4 trillion. By my calculation, and in the model we estimated, as capital shortfall gets high, the likelihood of a financial crisis gets higher.

Now, there is reason to think that the debt in China is not as easy to ignite as in a capitalist market, because it is implicitly guaranteed by the state. Which begs the question: Is this private or public debt? I would argue a lot of it is public debt. But its market value is low, and the market cap of these banks is small compared to their liabilities. Consequently, it only takes a small change in their asset values to drive them into bankruptcy. But no one expects Chinese banks to go bankrupt. There is no need for the question of whether they are too-big-to-fail, because the state will simply bail them out.

But, on a related note, I think the effect of having these banks undercapitalised mean that they are not doing the business that banks are supposed to do, which is taking money from savers, and making loans to borrowers. And these borrowers are the people who should be willing to pay the most for the capital and those are the people that can’t get it - instead it is going to state owned enterprises. The allocation system is not working properly and I think that is one of the main reasons they are slowing down.

CFM:    

You noted that the shortfall of US banks is growing rapidly. Is this a worrisome trend, or is it likely just for temporary, idiosyncratic reasons?

RE:    

I think the increase in US banks’ shortfall is probably attributable to the steps taken towards deregulation. At the same time, the initial tax cut for these banks and the deregulation actually makes them look like they have got excess capital. I think it is dangerous in the US, but at the same time, the probability of a crisis here is still below 50%.

CFM:    

In a recent interview Professor Anat Admati of Stanford University was speaking about banking regulation that you just mentioned. She argues for tougher regulation to reduce fragility in the banking system. But banks can’t auto regulate, and regulators have been shown to be typically ill-equipped for the task. Do you have any notion (or proposal) of what effective regulation might look like? Especially in terms of capital requirements?

RE:    

I don’t have a quantitative number – it is in any event difficult to pinpoint. But, we are doing research on this topic and one of the things that we have seen, interestingly, is that there are quite a few countries in the world where the banks are overcapitalised. This is especially prevalent in emerging market countries, where not enough risk is being taken. It simply means that they are not making loans that should be made. Many of these banks might not be pushing at the margins in trying to find entrepreneurs that they can lend money to.

We use a total capital ratio of 8%, with some divergence amongst banks being over or undercapitalised with this as the midpoint level. Our work shows that this ratio is not far from what should be a reasonable measure.

CFM:    

If I may move into some of the contemporary topics being discussed in the finance industry. A recent Financial Times article highlighted survey results showing that various CIOs and other decision makers identified climate change and AI as the two global trends most likely to transform the asset management industry.13 Do you share this view?

RE:    

I think AI will change all sorts of things. I am not so convinced it has much to offer for financial markets.

As for climate change, and ESG more generally – it is clearly a big driver of investment appetite, and I think asset management firms and hedge funds are falling all over themselves trying to figure out what products they can offer. It seems to me there are different motivations. If, for instance, a portfolio manager is to take into account any of a large assortment of ESG-like factors or metrics, a profibility is likely to take a hit in the short run. But, such investments are likely to pay-off in the long run. This is related to the concern that financial markets have a bias toward short-termism. So, it might be that one of the effects of sustainable investing is that markets are prompted to figure out how to let companies make profitable investments that take time.

CFM:    

In this same FT article, the research not only suggests that AI and climate change are the two major trends, but ironically, that these are the issues asset managers are most ill-prepared to address. If you were managing money for investors, how might you go about integrating their demands?

RE:    

That is a little unfair! I am not very optimistic that having ESG scores, especially the way that they are being compiled – taking weighted averages of these across a firm, then weighting the firms in your portfolio by this measure – gives you a portfolio with a very coherent purpose. That is partly why I did research on climate change, and how one may go about hedging for it.14 The idea with the portfolio we created is that; what one would really like; the reason one might invest in the ‘E’ part of climate change; is to hedge against the worst outcomes of climate change.

CFM:    

The one thing I found striking about this research – given we touched upon short-termism earlier – is that the hedging is done on a relatively short timescale, whereas dramatic climate change effects are only likely to manifest over a longer timescale. How did your research marry this timeframe misalliance?

RE:    

If you want to know which firms will be best positioned for a ‘bad’ climate outcome in 50 years, you will have to do a lot of crystal-ball-looking. There are many unknown unknowns: companies will change their lines of business, we will have technological innovation that we didn’t anticipate, etc. So it seems to me you can’t really expect a fund to figure that out. Instead, what you want to do as time goes by, is update your valuation using new information in a dynamic portfolio.

How do you do that?

We want to know when ‘bad’ news about the climate hits the wires, which stocks investors buy, and which ones they sell. The reasoning goes that investors are likely to buy those firms that are best positioned to withstand a ‘bad’ climate scenario, and they are going to sell the ones that are likely going to be hurt. They should, in all likelihood, probably be selling, for example, stocks with high fossil fuel reserves and buying ones that offer a promising approach to mitigate climate change. That is what we are trying to figure out.

Nevertheless, the market doesn’t easily reveal any portfolio indicating a climate change premium, and the evidence is not significant as to what such a hedging portfolio may look like. However, if you create such a portfolio, and you suppose there is a significant event that galvanises investors’ views on climate change, this portfolio may become more revealing, and we will have a better idea of who the winners are likely to be. And if you are a pessimist about climate change, this is likely the portfolio you want; if you are an optimist, then you’ll probably play the other side.

CFM:    

It is interesting that you frame the desire for such a hedging portfolio as optimist vs. pessimist, in that it speaks to a level of conviction one might harbour about climate change. It reminds me of a recent poll that showed the US being the most sceptical nation about climate change and its cause.15 Following your reasoning, an investor in Europe is therefore likely to act in a meaningfully different way than his or her average counterpart in the US.

RE:    

Right. This will probably speak to how, for example, a fossil fuel firm is priced. A European investor might assign a lower value than a US investor, and if one follows this reasoning, it is likely that US investors might accumulate a bigger share of the fossil fuel industry than European funds.

What is important, however, is to ask: How do you value a fossil fuel company over the next 50 years? And that depends a lot on what you think is likely to happen. If there is a risk that fossil reserves are going to become stranded assets – do you want to hold or short that risk? If you want to hold that risk, it is probably akin to earning a risk premium.

CFM:    

In your paper, you made a very important distinction between ‘physical’ and ‘regulatory’ risk, and to me this is particularly relevant given the competing views about regulation and any likely regulatory responses. How, in the current climate of protectionist and nationalistic rhetoric, do you think we square this with what is an inherently global problem, calling for multilateral action?

RE:    

I think that is the most salient feature of what we are living through right now. Most of my colleagues and I here in the US think the government should respond, regardless of whether they believe climate change is manmade or not. They should be able to act and adapt to its consequences.

I also think there is energy in the US around the idea of the private sector picking up the slack, but I don’t believe they can to the extent that it is needed – at least not until prices are rationalised. One cannot expect the private sector to embark on massive infrastructure projects such as, for example, sea-walls or early warning systems – these are all collective public goods and would require at least some government involvement.

CFM:    

This is in line with a growing call to action amongst business leaders and CEOs of large asset managers to take ownership of the challenge. One could argue this is a slippery slope as it usurps the authority and responsibility of governments and policy makers. There is a difference between investment convictions of how funds should be invested, versus doing so in response to a lack of regulation or government failings.

RE:    

The best we can hope for, and the best I think we should expect from the private sector is that they make wise investments from a present discounted value point of view. In other words, if there is, for example, energy saving technology that firms could use, but it takes ten years to realise, markets should be more patient in seeing those opportunities realised.

 

11See account of the ECB monetary policy meeting here

12Please refer to the website of the NYU Stern Volatility institute and the SRISK page for further details: click here

13Financial Times, 15 September, 2019 ‘AI and climate change transform investment sector’: click here

14See the paper by Engle et al. ‘Hedging Climate Change News’ here

15See the YouGov pole results here

 


 

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Find details of Professor Engle’s research, a list of upcoming conferences, and other news on his faculty website here

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Refer to the website of ‘V-Lab’ for analysis and documentation of the Systemic Risk (SRISK) tool, along with a host of other quantitative analysis here

Professor Engle spoke with André Breedt, Research Associate in the Paris office of CFM.

 

DISCLAIMER

The text is an edited transcript of an interview with Professor Robert Engle in September 2019 in New York. The views and opinions expressed in this interview are those of Professor Robert Engle and may not necessarily reflect the official policy or position of either cfm or any of its affiliates. The information provided herein is general information only and does not constitute investment or other advice. Any statements regarding market events, future events or other similar statements constitute only subjective views, are based upon expectations or beliefs, involve inherent risks and uncertainties and should therefore not be relied on. Future evidence and actual results could differ materially from those set forth, contemplated by or underlying these statements. In light of these risks and uncertainties, there can be no assurance that these statements are or will prove to be accurate or complete in any way.
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