2017 came and went without nary a whimper. None of the big concerns at the end of the previous year happened or at least global capital markets did not seem to be disturbed by much of anything.
Stocks went up in a straight line, bonds did ok, volatility was super low and at the end of the year exuberant expectations were in full bloom as everybody and their aunt became fixated on Bitcoin
The global economy keeps doing well and memories of the 2008 Financial Crisis are receding.
Consumer sentiment remains upbeat. Maybe some drama out of Washington but generally smooth sailing.
Being an investor is wonderful when markets are calm and 401K statements show gains month after month. Everybody is an investment genius.
We forget how painful it is when markets experience stress and things get a bit crazy.
Similarly we tend to forget how lucky we are at times such as in 2017 when capital markets deliver bountiful gains.
Clearly, we would all love smooth capital markets forever, but …
The close friend of return is always uncertainty. The two are inseparable even though they may not always be in direct contact
What is uncertainty in the capital markets?
There are as many ways of defining uncertainty as there are opinions as to who the greatest quarterback in history is (we all know it is Tom Brady, right).
My favorite way to visualize uncertainty is as a bell-shaped distribution of potential outcomes — the good and the bad with a lot happening in the middle.
We fear the left tail where things go terribly wrong, we accept the middle of the distribution as textbook risk/return, and we think that our own brilliance (just joking, of course) has led us to the right tail of the distribution.
In 2017 equities, in particular, had a monster year with the S&P 500 up over 25% and many international markets up even more. The year turned out much better than expected. What do I expect for this coming year?
My baseline capital market scenario for 2018 is fairly benign — some people would call it boring. A quick review is in order.
- I expect equities to again do better than bonds
- I also expect international assets to outperform domestic strategies
- My most likely scenario for this year is for continued growth, subdued inflation and no major equity or bond market meltdowns
In my judgement there is about an 80% probability that such a Goldilocks scenario plays out in 2018.
On the downside I expect the low volatility of last year to once again revert back to risk on/off.
I expect to see more large jumps in market prices caused by low probability events lurking in the left hand side of the distribution. The press calls these events Black Swans.
On the other end of the uncertainty distribution you have what I call Green Swans — events, low in probability that when they happen are wildly positive for investors.
What could cause a Black Swan in 2018?
- An inflation spike caused by a sustained rally in commodity prices
Inflation in the US is currently running a bit above 2% and market participants do not expect to see any major revisions over the next two decades (see the Philadelphia Federal Reserve estimate of inflationary expectations).
Forecast complacency has set in and inflation risks are to the upside. An overcrowded trade as traders would say
The immediate effect of an upward spike in inflation would be a rise in bond yields. Equities would probably take a short-term hit but the primary casualties would be found in the fixed income market.
What could cause a sustained surge in commodity prices? One, could be a supply disruption say in the oil market. Oil is once again showing signs of strength.
Another could be a resurgence of global growth and continued demand for commodities such as iron ore and copper.
Third, a depreciating US dollar leading to a ramp up in commodity price inflation.
- A spike in capital market turmoil caused by a Geo-Political Blowup
The blowup could be anywhere in the world but most political commentators point to North Korea and Iran as the most likely centers of conflict.
Another possibility is a cyberattack endangering public infrastructure facilities especially if it is sovereign sponsored. Third, Jihadi terrorism on a large scale and on high profile targets. And last, the outcome of the Special Counsel investigation into Russian meddling.
All of these events have blowup potential.
Global economic growth would also, no doubt, loose some of its new found momentum.
- An avalanche of bond defaults in the apparel and retail industries in the US and/or a debt bomb crisis in China
It is no secret that the US apparel and retail sectors are going through massive consolidation driven in part by the shift to online shopping. It is widely acknowledged that the US retail market is over-built.
The number of apparel and retail companies expected to disappear is higher today than in 2008 during the Financial Crisis. Read here for a list of apparel and retailers at risk.
According to the Institute of International Finance global debt hit a record last year at $233 trillion. Debt levels as a percentage of global GDP are higher today compared to 2007. Figuring prominently in the debt discussion is China.
The IMF recently issued a warning to the Chinese authorities about the rapid expansion of debt since the 2008 Financial Crisis. The rapid expansion in debt has funded lesser quality assets and poses stability risk for global growth according to the IMF.
Estimates by Professor Victor Shi at UC San Diego put Chinese total non-financial debt at 328 percent of GDP. Other estimates are even higher leading to an overall picture of rising liabilities and numerous de facto insolvencies.
The implications of a debt scare for investors are quite dire. Investors have had plenty of experience with debt crisis in recent years — Greece and Cyprus come to mind as Black Swan events that temporarily destabilized global capital markets.
A Chinese debt scare would no doubt be of great impact to investors. Emerging market debt spreads would certainly blow up.
What about the right hand tail of the uncertainty distribution — the Green Swans?
These are wildly positive events for investors that carry a low probability of happening.
What type of Green Swan events could we hope for that would lead capital markets to yet another year of phenomenal returns?
- A positive global growth surprise possibly brought on by the recently enacted US tax reform
The US is the largest economy in the world and still remains a significant engine of global growth. Could we be surprised by a spurt in US economic growth this year?
According to the Conference Board US real GDP is expected to growth 2.8% in 2018.
Could we see 4% growth? The President certainly hopes so. Not that likely. The last time that US GDP growth was above 4% was in 2000.
What could give us the upside scenario for growth? Maybe a jump in consumer spending (representing 2/3 of GDP) driven by real wage growth and lower taxes.
Another possibility is a surge in investment by US corporations driven by cash repatriations and recently enacted corporate incentives.
We view both scenarios as realistic but providing only a marginal boost to growth. Sorry, Mr. President!
- A spurt in exuberant expectations driven by the cryptocurrency craze
Fear of missing out (FOMO) takes over repricing all investments remotely tied to the cryptocurrency craze along the way.
We saw a similar scenario play out in 1999 in the final stages of the Technology, Media and Telecom (TMT) bubble.
In those days TMT stocks were no longer priced according to traditional fundamentals but instead on the idea that laggard investors would buy into the craze and drive prices even higher.
Lots of investors succumbed to FOMO in the final stages of the TMT bubble
The recent price action of Bitcoin and most other cryptocurrencies has a similar feeling to the ending stages of the TMT bubble. It is almost as if Bitcoin and its cousins are being discussed along with the latest Powerball jackpot.
No doubt fortunes have been and will continue to be made in cryptocurrencies.
Blockchain technology which underlies the crypto offerings is here to stay, but I worry about the lack of investor education and the speed of price action in late 2017. Whatever happened to Peter Lynch’s “buy what you know” approach?
What could we see if exuberant expectations make a sustained comeback?
First, technology stocks would continue out-performing. Chip suppliers such as Nvidia and AMD would continue to see massive growth.
Companies adopting blockchain technologies would see their valuations increase disproportionally.
Animal spirits would be unleashed onto the capital markets making rampant speculation the order of the day. The primary beneficiaries would be equity investors with aggressive portfolios.
History tells us that it is almost certain that after 8 years of an economic expansion and stock market recovery we should see an outlier type of event in 2018. What shape and form it will take (or Swan color) we don’t know.
Preparing for tail risk events is very expensive and under most scenarios not worth bothering with. Focus on the big picture instead. Predicting tail events is possible only in hindsight.
Black Swans create great distress for investors, but the opportunity cost of playing it too safe is especially high today given prevailing interest rates that fail to keep up with inflation.
The fear of missing out (FOMO) during Green Swan events is also a powerful investor emotion. Again playing it too safe can result in many lost opportunities for capturing significant market up moves.
Investing is all about weighting these probabilities and focusing on a small number of key fundamental drivers of risk and return.
Most to the action takes place in the middle of the distribution of potential outcomes.
How you structure your portfolio and navigate the uncertainties of capital markets is important to your long-term financial health.
Watch those tail events but don’t become paralyzed by fear or greed — these are after all low probability occurrences.
Have a realistic and well thought-out financial plan in place and if needed have an experienced Captain Sully-type as your captain.
Focus on the big picture and live your life!
None of this shall constitute an investment recommendation. Consult your wealth manager if you need help. A version of this note first appeared in Financial Insight Strategists.
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