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The real cost of regulations

Exploring links of market volatility to non-market factors

by Thomas Schellen

In our relentless pursuit to unravel the equities markets’ mysteries of 2016, Executive sat down for a further conversation with Paul Donovan, the managing director, Global Economics at UBS Investment Bank.

E   What do you make of market behaviors in the first six weeks of 2016?

One always expects some volatility but market volatility in 2016 has been very unusual. There is no economic justification for what we are seeing. So why do we have these problems? I think it is partly because equity markets and economies are not the same thing. Equity markets are biased towards energy and manufacturing; economies are service centric. Equity markets are [populated by] large companies, while economies are small companies. Equity markets are export focused; most economies are not. If we go back 20 or 30 years, the S&P [Standard and Poor’s index] was roughly like the United States economy; today it is nothing like the US economy. I think this has surprised people and there is still a belief that equities and economies are one and the same.

E   But there surely had to be short-term factors involved in causing the amount of upheaval we have seen?

The severity of the oil price move has also been a surprise for the markets. The difficulty now is in looking at the rest of the year and asking to what extent will economies influence markets and to what extent do other factors influence markets. Things like positioning, regulations [and] political risk are of course all important factors and I think these will be the next challenges for us.

E  Can such developments still be discussed in terms of market dynamics or is everything simply human behavior?

I think there is a market issue here. [The recent period] has been the first really significant movement in markets since the crisis of 2008/9 and, perhaps more importantly, since the regulation that followed the crisis. The issue with regulation is of course that there is always some unintended consequence; this is now a world where banks provide less support to the markets than they used to do. This is because they are more regulated. I am not saying regulation is bad, but this is a consequence of where we are. So when I look at the markets, we are now perhaps seeing some of the true costs of regulation come through with this increase in market volatility. We should perhaps not be surprised. The question now is  if this is an acceptable price to pay for the benefits that regulations give us, or do we need to reconsider [this strategy].

E  Does the belated emergence of the cost of regulations explain all that we are seeing in markets?

In terms of behavioral economics, I think it is a mixture of behavioral issues, regulations and market pressures that have created this push to quite short-term investment [horizons].

One of the things in defense of markets is that economic data has become less reliable and subject to larger revisions. We saw an example just today with US retail sales in December being corrected from minus 0.2 [percent] to plus 0.3. This is not a small change, shifting from saying that consumers are not buying anything to saying they are actually buying quite a lot. Over the past six years, GDP data in the US has been revised up 74 percent of the time. Markets are dealing with less reliable data and that perhaps represents a confused picture. On the behavioral side as well, because we are in a low-return environment, I think a lot of people in markets are very nervous.

E  Do fears come out stronger in times of uncertainty?

The problem we have is that to understand what is truly happening in the economy, we need to take a very broad approach, but this requires a lot of effort, looking at lots of different data items and understanding them. What I find is that we economists are often asked to name five key economic indicators to watch for in the US or Germany. The [real] answer is you shouldn’t look at five because three of these indicators might need a revision next month and then you are looking at the wrong signal. Many people working in markets have grown up with a mindset of paying attention to certain favorite data releases. That can be a very hard habit to break. People fixate on an individual data release or several indicators rather than on the big picture and that perhaps creates the problems that we see now.

E  In your view, is it true that potentials for cascading risks, as described in the World Economic Forum’s latest Global Risks Report, are on the rise? There are potential economic impacts, even if the top perceived risks are not economic ones such as the failure to mitigate climate change or involuntary mass migrations, with the Fourth Industrial Revolution as an added factor – what do you think? As we face such complex risks and cannot accurately assess and deal with their interconnectedness, should we as humans perhaps just hand management over to robots?

The whole issue of the impact of the Fourth Industrial Revolution is going to be quite significant. We did a white paper on this for Davos in which we ranked a number of economies according to their likelihood to succeed in light of the coming changes. What this test revealed is that while many developed economies are doing very well, countries like China, Brazil and India are positioned very poorly.

[pullquote]Many people working in markets have grown up with a mindset of paying attention to certain favorite data releases. That can be a very hard habit to break.[/pullquote]

E  What are the critical factors deciding the propensity for success or failure?

The criteria for success, and this applies to countries as well as companies, are having a relatively highly skilled labor force and a flexible labor force. You have no benefit from engineers who have memorized text books – you need to train people on how to change and how to be able to adapt. Other important factors are innovation and the rule of law. In a world where I export a computer code, not a finished product, I need to be confident that you can’t steal my code and that if you do, I can sue you and get my money back.

E  Would you see any Middle Eastern economies on the “likely to succeed in the Fourth Industrial Revolution” list?

In looking at issues surrounding the Fourth Industrial Revolution we have to be honest: many Middle Eastern economies are not well positioned. [A country like] the Lebanon is perhaps better positioned to be able to adapt. The Lebanese had to adapt a great deal in the past 30 years. But when we look at some of the Gulf states, we see countries where the middle class is not getting a very flexible education enabling them to adapt. These are countries which, for the past 40 years, have remained single-commodity countries, focused on oil and petrochemicals. Despite the opportunity to change, many of these countries have remained structured around a single product.

E  Looking to developed markets, are doomsday scenarios impacting your thinking, such as predictions that United Kingdom GDP would suffer severely with a Brexit?

We have obvious tail risks in the economy. The political risk is quite prominent, I would say. We have risks in this region and from this we have the refugee crisis which has changed policies in Europe. Now we have fears that if [German] Chancellor [Angela] Merkel were to leave, this would increase uncertainties in markets, given her leadership role in Europe. There are a variety of risks and you have to assign probabilities to them. A UK exit from the European Uunion is a moderate risk in terms of both likelihood and severity; our base case is that the UK remains in. If the UK exits, then the question is what sort of exit? If the UK were to exit against our expectations, it would be what we call a soft exit; it would be negotiated so that there would not be a great deal of disruption. However, there would be consequences which would be moderately negative for the UK and negative for Europe. Without being too British about it, I think if the UK leaves it will lessen Europe.

E  Have you noticed any new questions, shifts in attitudes, any rise in fears in behavior of your Lebanese clients?

There have been some interesting issues, such as the discussion of the oil economies. In that context there has been discussion of repatriation flows from Lebanese working overseas as they are impacted by the lower oil price. But in talking with the entrepreneurs in the region, it is very interesting that many of them are saying: “While markets have been messy, we are not seeing our businesses being affected.” Demand for our products remains relatively firm from Europe and indeed from the Gulf. The Gulf has yet to cut back spending significantly, at least not on the sort of products that Lebanon has been selling in the Gulf. It is worthwhile to keep monitoring the situation very closely, but so far it seems that Lebanese entrepreneurs have been cautiously upbeat about how their companies are performing regardless of how the equity markets are performing.

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Thomas Schellen

Thomas Schellen is Executive's editor-at-large. He has been reporting on Middle Eastern business and economy for over 20 years. Send mail

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