Recently I was in Rome and as I was walking in a narrow street near the Spanish Steps, I noticed a crowd had gathered in front of an expensive hotel. People had their smartphones ready to take pictures, perhaps aspiring to become paparazzi. I asked one of them who they were waiting for and the answer, amazingly, was “I don’t know actually but because everybody is standing here, there must be somebody important inside so I want to be ready to take a picture when he/she comes out.” I continued my walk thinking about how easy it is to push people into herding behaviour. Hopefully, at least one individual will have known who was supposed to come out of the hotel to jump in a limousine, in which case the uncertainty for the crowd was limited to timing (when will he/she show up?) and timespan (how long will he/she be visible?).

We have seen something similar in financial markets as of late. Equities have sold off and judging by the economic data, this looks like an exaggeration. Admittedly, data have been mixed but not to such extent as to justify the drop we’ve seen. The oil price decline has been a big driver of negative sentiment since the start of the year. One interpretation is the ‘paparazzi model’: oil is down, this must signal a weakening of demand and this is enough a reason to sell stocks (just like a crowd in front of a hotel must mean there is a celebrity inside). The fact that the downward trend in oil prices is a reflection of a supply glut which creates a huge windfall for oil importers is completely ignored in that view. This may be due to a second interpretation which I would call the ‘ambiguity model’: whereas there is certainty about the negative effect of cheaper oil on the producers (increasing default risk of US shale oil producers; cutbacks of investments by oil majors; rising financial pressure in many oil exporting countries), there is ambiguity about the extent to which cheaper oil boosts spending of the oil importing countries. Clearly, consumers benefit directly when filling up their car but they may save some of the money if they feel uncertain about the economic outlook. Companies will probably attach even more importance to the uncertainty factors considering that recruiting new staff and extending capacity are long horizon commitments. They will want to see how permanent the decline of oil prices is and how other sources of uncertainty (e g Chinese growth, evolution of manufacturing activity) evolve. A third interpretation is the ‘tail risk model’. The price of an asset at any moment in time reflects the implied distribution of expected values of the asset price drivers. Investors will attach a probability to GDP growth over the coming year to be below 0%, between 0 and 1%, between 1% and 2% etc. Same thing for interest rates, earnings growth etc. In each case this will have an impact on the theoretical price today for equities, bonds, the currency etc. Extreme scenarios would imply a very low or very high price but the impact on today’s stock prices is diluted because of the low likelihood of an extreme event happening. However, when markets are moving swiftly, when many developments are occurring simultaneously, when investors struggle to see the forest from the trees, risk aversion starts to dominate and investors will attach a higher likelihood to tail risk scenarios: what would happen to producers if oil would go down a lot further? How non-linear could the economic consequences be? This is at least part of the story of what we have seen in January in terms of reaction to ever declining oil prices. Against this background the recent news that Russia would be keen to discuss with OPEC on a reduction of supply is of course important although it doesn’t mean that a deal will be reached. It a reminder though that oil prices depend on market forces but also on how key countries approach the market.