The people that are paid to worry about risk advise that there will be no shortage of things to fret about in the year ahead —from the macro (global demand) to the micro (hedge funds) to the imponderable (terrorism). Investors that aim to be prepared for every eventuality will have their work cut out for them in 2006.

Market and economic forecasters predict that 2006 will resemble 2005 in many respects. But professional worriers can spot any number of things that could spoil that sanguine view. “We worry about everything; that’s our job,” admitted Bank of Canada governor David Dodge at a press conference for the release of the latest Monetary Policy Report update.

At the top of Dodge’s list is the stability of global demand. For the coming year, he says, the big question facing the global economy is whether domestic demand in Europe and Asia will prove strong enough to pick up the slack for an expected weakening of U.S. demand.

The central bank’s concern about the resilience of global demand is echoed by one of the world’s most important regulators, Britain’s Financial Services Authority. The FSA publishes an annual report highlighting its outlook for risks in the coming year. This year, that report singles out the strength of global demand, sustained high oil prices and the threat of a disorderly depreciation in the U.S. dollar as the key macro risks.

Worries about the potency of global demand and the prospects for the US$ arise against the backdrop of continued growth of global fiscal imbalances. These are ultimately unsustainable — stoking fears that a rapid, disorderly unwinding of those imbalances could significantly disrupt global financial markets.

The Bank of Canada indicates that it sees upside and downside economic risks as equally balanced in 2006 but tilting toward the downside in 2007 and beyond. “Should the unwinding of global imbalances involve a slowdown in world economic activity, it would imply lower net export volumes, lower commodity prices and less growth in business investment for Canada than in the base-case projection,” it warns in the latest MPR update. And if this unwinding is accompanied by a sharp fall in the US$ against the Canadian dollar, demand for Canadian exports would take an even bigger hit. As demand falters, growth slows; often falling profits and job losses aren’t far behind.

But while global capital flows present risks at the most macro level and may take a long time to materialize, there is no shortage of more immediate threats. Hedge funds is certainly one. In late January, Bank of Montreal held an analyst conference with its top risk-management personnel, ostensibly to highlight its superior skill at controlling credit losses. In that conference, the bank’s chief risk officer and executive vice president, Bob McGlashan, warned that hedge funds are likely to be the focus of the “next nuclear explosion” in the financial markets.

Hedge funds have been an ongoing source of concern since the Long Term Capital Management LP debacle in 1998. But over the past couple of years, fears have intensified as hedge funds have proliferated and the participation of retail investors — whether directly or through structured products — has rocketed. The growth in hedge funds has made them much more significant players in financial markets, accounting for a large chunk of the trading action. If and when there’s another massive failure in the hedge fund industry, the pain may be more widespread than in the past.

“Somewhere there’s going to be some big hedge fund losses,” McGlashan warns. “That, in and of itself, isn’t a big deal. But when combined with the fact that hedge funds are reaching into the retail investment community, in which you have relatively less informed investors taking risks that they don’t really understand, that will elevate the nature of the concern.”

Hedge funds’ traditional opacity makes it difficult for investors —both retail and institutional — to assess their risk exposure or underlying portfolio correlations. McGlashan indicates that this makes BMO very cautious about the hedge funds it uses. “Not all hedge funds are created equal, but most of them operate on the black box theory. “When you combine that with our fundamental premise of ‘know your client,’ what [hedge funds] do and how they do it — and they won’t tell you — is a problem,” he says. “You had better be very careful how you deal with those, and with whom you deal. And we are. We’re very selective as a result of that.”

@page_break@Indeed, the BMO conference highlighted the bank’s KYC discipline as one of its key tactics for minimizing its risk exposures. For example, McGlashan explains that BMO’s commitment to KYC was the primary reason it was the only Canadian bank that didn’t take a major hit from the collapse of Enron Corp.

“We were involved for a while,” McGlashan says. “Then we were asking questions about the next transaction — trying to understand what the value of the transaction was, what the basis of the transaction was: Why are you doing this; where’s the business case?

“When there wasn’t one that made sense to us — even though it looked like you couldn’t necessarily lose money — we exited,” he says.

Credit cycle

Whether hedge funds are indeed the site of the next nuclear explosion or not, the evolving credit cycle probably presents a conventional market risk in the year ahead. In fact, UBS Securities Canada Inc. has identified the expected deterioration in credit quality as the biggest operational risk facing the Canadian banks in 2006.

In a report issued last year, UBS suggests that a gradual return to a more normal level of loan-loss provisioning at the banks from current levels (without an increase in margins) would more or less erase any earnings growth, actually creating a small decline in earnings. Under a more extreme scenario — if credit costs were to revert to their historical high — earnings could take a 20% hit, UBS warns. It suggests that improved risk management at the banks should help cushion the blow of declining credit quality.

The banks may indeed be better equipped to deal with credit risks today than they have been in the past, but the FSA is still worried that financial firms may not be adequately prepared to deal with some of the more extreme scenarios that they could face, such as a global pandemic or a major corporate bankruptcy. It also worries about the operational and insurance risks associated with terrorism and financial crime, the increasing risk of financial fraud and financial firms’ ability to deal with the volume of international regulatory reform.

At a more technical level, some market-watchers are also on the lookout for risks associated with financial reporting and transaction processing. The credit rating agency Fitch Ratings Ltd. warns that while it expects the coming year will be calmer in terms of financial restatements by companies, potential accounting risks remain — particularly as the shift to international accounting standards accelerates. Along the same lines, the FSA highlights potential valuation problems with illiquid financial instruments and risks associated with the backlog in unconfirmed derivatives transactions. All of these are risks that, should they materialize, would probably reverberate throughout the highly integrated global financial markets.

Consumer risks

Finally, there are emerging risks at the consumer level. Heavy debt loads and minimal savings may limit consumers’ ability to deal with an economic slowdown. Moreover, the FSA says, it is concerned about the average citizen being forced into the role of retail investor, a situation that’s occurring in Canada, too. It warns that increasingly complex financial decisions will pose a challenge for many consumers, as they are being required to take more responsibility for financing their retirement. “The quality of consumer advice and the level of consumer financial capability will be particularly critical issues, because of the increasing complexity in both consumers’ needs and the products being introduced in the marketplace,” it cautions.

From concerns about the capability of the small consumer to the unwinding of massive global imbalances; from the exotica of high-octane hedge funds to the routine turning of the credit cycle — for worrywarts, there is no shortage of risks to fret about this year. In such circumstances, effective diversification and a strong stomach may be investors’ best hope. IE