As
investors scramble for yield in markets awash with central bank
liquidity, their eyes continue to be drawn toward the glitter
of emerging markets, including those in the Middle East and
South Asia, where I’ve been trolling for the past few
weeks to probe the links between portfolio strategy and tail
risk. Few countries offer as much fertile ground for such
ruminations as Pakistan.
The Islamic Republic has its own special charm for
diplomats, soldiers and spies, who worry about different risks
emerging from the country and its growing stockpile of nuclear
weapons. But below the Bloomberg radar, Pakistan may also have
the potential to perturbate global financial markets. My time
in Islamabad was brightened by winter sunshine and darkened by
conspiracy theories.
“Assassinations, mayhem and lack of rule of law in some
emerging-market locations often make them a marginal sideshow
to global macro markets,” says Thomas McGlade, portfolio
manager at London-based hedge fund Prologue Capital. “Even
Syria can hardly get the attention of the markets, so the low
boil that is constant in Pakistan rarely registers. But
it’s the security and nuclear dynamic which could push
Pakistan to the forefront.”
My diplomat friends aren’t eager to see a crisis in
Pakistan, but some traders take a different view. Global macro
hedge funds are starving from a lack of volatility, which is
their lifeblood. Europe’s financial markets have healed
dramatically since Mario Draghi promised last year to do
whatever it takes to save the euro. The decision by Washington
lawmakers to avoid any fiscal cliff–diving has provided a
similar tonic on the other side of the Atlantic. China’s
policymakers have engineered a soft landing for their economy.
The civil war in Syria hasn’t spilled over into
instability in the Gulf or posed a threat to global oil
supplies. And on top of it all, central banks in Europe, Japan,
the U.K. and the U.S. continue to pump liquidity willy-nilly
into global financial markets, forcing everybody into
higher-risk, higher-return assets.
All in all, it’s a pretty benign environment for the
global economy but one that makes macro traders squirm. Returns
at many hedge funds lagged their benchmarks in 2012, and a lot
of investors are still smarting about the 2 percent fees.
“We could really use some volatility right now,” one
London-based trader complained to me over a curbside lager at a
Mount Street pub in Mayfair. “It’s hard to make money
when things are this quiet.”
And so macro traders have their ears to the ground for the
first rumblings of turmoil. “There is still a desire to
find, or anticipate, the next ‘tail event,’ and there
certainly will be others going forward,” says Adam
Crisafulli, head of market intelligence at J.P. Morgan in New
York.
A couple of traders in New York and London told me that
Pakistan was on their list of prime candidates for tail risk. I
found this intriguing since I was headed there anyway. How much
of this perception is real and how much is the cinematic
reflection of Zero Dark Thirty, the gripping Kathryn
Bigelow movie about the search for Osama bin Laden?
(Not that I’m immune to cinematic reflection nor to
what I thought was Bigelow’s sympathetic portrayal of my
former CIA colleagues. The film’s bombing scene at the
Islamabad Marriott prompted me to stroll over and have tea at
the hotel’s lounge, for old time’s sake. Navigating
the Hesco barrier gauntlet and double-thick blast walls that
were erected after the actual 2008 attack was a minor hassle,
but no more so than trying to enter any U.S. embassy in this
part of the world.)
On my way to Pakistan, I heard plenty more risk scenarios on
a stopover in Dubai. The iPhone told me it was freezing in New
York and snowing in London as I smoked shisha, or flavored
tobacco, by the pool of a luxury hotel with a random scrum of
traders, investors, entrepreneurs, retired diplomats, soldiers
and people who describe their work simply as “export and
import.” We bathed in the reflected light of the Burj
Khalifa tower on a balmy 20 degree Celsius evening. I confess
that I haven’t enjoyed a hookah so much since 1973. And
yes, I inhaled.
According to portfolio managers, an emerging market like
Pakistan could trigger one or more of four possible convulsions
that would jolt markets.
For starters, something really bad could happen in an
emerging market that would derail GDP growth in one of the
bigger BRICS. The obvious risk here is a Pakistani economic
implosion with spillover effects on its Indian neighbor. The
economy enjoyed several years of nearly 7 percent growth in the
mid-2000s under the leadership of reformist prime minister
Shaukat Aziz, but political instability and mismanagement have
sapped its strength in recent years. The assassination of
former prime minister Benazir Bhutto in December 2007 unleashed
a wave of violence, including the 2008 Marriott bombing.
Bhutto’s widower, Asif Ali Zardari, won election as
president in 2008, but subsequent governments have failed to
pursue reforms, crack down on corruption or get a grip on the
deficit; foreign investment has slowed to a trickle. The
result? Growth has averaged only about 3 percent a year since
2008 and is projected by the International Monetary Fund to be
a sluggish 3.25 percent in the fiscal year ending June 30.
There’s also the possibility that a South Asian crisis
could interrupt the smooth flow of petroleum from the Gulf.
Unlike Iran, however, Pakistan isn’t in a position to
choke the Strait of Hormuz. To the contrary, in January the
Pakistan Navy engaged in joint naval exercises with the Royal
Saudi Navy to help secure the Gulf passages and the Horn of
Africa against Iranian interference and Somali piracy.
Moreover, the Pakistanis are close to being choked themselves.
Many of the offices and residences in Islamabad are
unpleasantly cool in the evening chill; there isn’t enough
natural gas to turn on the heaters because the national oil
company is virtually bankrupt. There are quarter-mile-long
queues at every gas station. So this aspect of Pakistani tail
risk is vanishingly low, in my view.
Alternatively, a terrorist attack linked in some way with an
emerging market’s domestic struggle could spook markets,
particularly if the epicenter is Canary Wharf or Wall
Street. Pakistan is still the center of gravity of the
global Al Qaeda network, even after bin Laden’s removal.
(As I walked back from the Marriott, it struck me that the CIA
analyst played by Jessica Chastain in Zero Dark Thirty
is a full generation younger than my former colleagues who
supported the Afghan mujahedeen proxies against the Soviets and
did so hand in glove with Pakistan’s Inter-Services
Intelligence Directorate, the ISI.)
At the far end of the scale, and most ominously, a nuclear
event would trigger raw market panic. Pakistan is on its way to
becoming the world’s fifth- or sixth-largest nuclear
power. The prospect that one of those weapons could fall into
the wrong hands, intentionally or not, is one of the few things
that actually keeps me awake at night.
After a three-hour hop across the Gulf, I arrived in
Islamabad and found the capital cool and much less tense than
on my prior trips. It’s quiet because occupancy is down,
explained the manager at the Serena Hotel. The day before I
landed, Imam Tahirul Qadri, a centrist cleric who advocates
good governance, disbanded 100,000 protestors who had flooded
the streets threatening to storm Parliament if the government
of Prime Minister Raja Pervaiz Ashraf didn’t promise new
elections and “throw out the corrupt
politicians.”
It’s cool because the sun rises late over the steep,
arid limestone Margalla Hills that frame the city to the North.
Islamabad itself is a sprawling, dusty metropolis; its
once-grand municipal fabric and splendid ministry buildings
show the effects of poor maintenance, economic stagnation and
the occasional suicide bombing.
There are checkpoints everywhere, staffed by police, and
Pakistan Army Rangers in olive-drab, long-shirttailed shalwar
kameez nervously fingering their AK’s as they huddle
around burning logs in the evening chill. They stand up to
shine a flashlight into the passing cars; then they usually
smile back, lower their guns and return to their sandbagged
fireside. I confess to ducking low in the front seat one
evening as a diplomat friend blithely waved to an anxious pair
of Rangers as she weaved her battered Toyota through a concrete
block checkpoint without braking.
Such frissons aside, I am fond of the city and its
attractive residents — resilient, clever, funny and hard
working. They manage to enjoy life in the face of adversity and
poor governance. During my visit, Islamabad’s buildings
were draped with elaborate festive patterns of lights in the
evening, celebrating Milad an-Nabi, the Prophet’s
birthday. Miraculously, these nighttime filigrees defy the
rolling brownouts and random power outages. The Ministry of the
Interior looked like Manhattan’s Tavern on the Green at
Christmas.
What is the probability that Pakistan will generate one of
the four tail-risk events that would move global markets? What
would be the timing and magnitude of such an event, and what
might be the early warning indicators — against the
backdrop of a falling or failed state?