Three ‘Black Swans’ that could ruffle calm markets in 2018
The statistician and philosopher Nassim Nicholas Taleb gave the name ‘Black Swan’ to an unpredictable, even highly improbably event that could have an unforeseen extreme impact and with global financial markets enjoying a period of remarkable calm advisers and clients need to be on the look-out for possible shocks to make sure they are not caught off guard in the year ahead.
Those advisers and clients with long memories will know all too well that financial markets are at their most dangerous when making money seems easiest. The healthy returns made from global equities in 2017 mean that there is some danger that market participants are lulled into a false sense of security, especially as volatility has been remarkably low.
Concerns over Brexit, sabre-rattling by North Korea, the indecisive nature of the German and Dutch election results, US Federal Reserve rate hikes, valuations in hotspots such as technology stocks and cryptocurrencies and President Trump’s protectionist leanings have all been brushed aside, as stocks have marched higher and shown remarkably little volatility – the FTSE 100 has moved higher or lower by more than 1% in any given trading day just 16 times this year, the lowest number of occasions since 2005.
Equity market volatility was very subdued by historic standards in 2017
Source: Thomson Reuters Datastream
However, even a cursory glance at the chart above will reveal that volatility rose sharply from its 2005 low, reaching a crescendo three years later.
This suggests that advisers and clients need to stay vigilant.
After all, everything seemed set fair 12 years ago only for everything to come unstitched three years later and then the source of the damage was a pretty unexpected one, namely a downturn in American house prices which, when coupled with some exotic derivative instruments, drained liquidity from global markets and left them with a debt pile that was difficult to manage.
It can be argued that liquidity and leverage (debt) are even more plentiful now so to spot what (if anything) could go wrong in 2018, then investors need to look at what could take away liquidity and again expose the world to its hefty borrowings. Such events are the sort of ‘Black Swan’ which could surprise markets and there is a chain of three interlinked events which could stir the markets out of their current complacency.
None of this is certain to happen and it may not – it would have been possible to argue this very case a year ago and you would have been wrong. But it shows markets could be surprised on the downside – as say the Trump tax cuts fuel the sort of inflation which tips wages, central banks and bond markets over the edge – and it takes a lot less imagination to come up with this scenario than one where a downturn in the Florida property market brings the global financial system to its knees.
In this column’s view, if there is to be a ‘Black Swan’ event in 2018, it could fly in from one of three possible areas, all of which are inter-linked in some way.
The first possible ‘Black Swan’ is a surge in wage inflation, especially as there are lots of very good reasons for believing why it should remain subdued.
In the UK it is possible to point to auto enrolment (meaning that workers are getting a better package but the benefits are back-end loaded and not strictly salary-related); the rise of self-employment; the development of the gig economy and job sharing; corporations being careful ahead of Brexit; the long-term emasculation of trades unions; and the rise of automation, as staff try not to price themselves out of a job and a robot into one.
Markets seem willing to extrapolate from 2017’s experiences, when (near) multi-decade lows in the unemployment rate of 4.3%, 4.1%, 3.6% and 2.8% in the UK, US, Germany and Japan respectively translated into wage growth for workers of just 2.5%, 2.5%, 1.2% and 0.6% for the same four countries in the last month when data was available.
But the market is trying to have it both ways by buying into the global reflation/growth narrative but doing so without pricing in any risk of inflation. If tight labour markets do finally prompt higher wages and a wider, faster advance in broad inflation readings then there could be trouble ahead for two reasons.
The first is companies will have to invest in fresh capacity, or more staff, or higher pay, or all three, if the currently preferred global growth narrative pays off. Corporate profit forecasts do not factor in such a rise in costs, especially in the USA, where investors are paying what is a high price by historic standards for what are historically lofty profits and margins – valuations leave little margin for error.
A surge in wage inflation could jeopardise US corporate profit margins
Source: FRED – St. Louis Federal Reserve database
The second is that central banks may start to tighten policy more quickly than the markets currently think.
Central bank policy
In November the Bank of England pushed through its first interest rate increase for a decade. In December the Fed raised rates for the third time this year and fifth time this cycle and Sweden’s Riksbank announced it would stop adding to its QE scheme.
Already this month, the Bank of Japan has reduced the amount of long-dated bonds it will buy as part of its QE programme by ¥10 billion for 10-to-25 year paper and ¥20 billion for 25-to-40 year paper. The ECB will also taper its monthly Quantitative Easing (QE) bond scheme from €60 billion a month to €30 billion in January.
In addition, the Bank of England is expected to eke out a second one-quarter point rate rise in 2018 and the Fed is targeting three more rate hikes and a continuation of its Quantitative Tightening (QT) scheme, whereby it begins to reduce monetary stimulus.
The pace of change is slow – but if wages pick up and inflation does the same then central banks could be forced to move more quickly, raising rates and tapering QE.
In the real world, even higher borrowing costs could be a burden, given that global indebtedness is at least a third higher than it was in 2007, according to research from McKinsey, at $200 trillion or probably more.
In the financial world, higher rates and less QE (or even QT) mean less liquidity, less cheap cash with which to buy assets. Central banks’ reducing their asset holdings rather than increasing them will be a test for bonds and equities alike, especially the latter, which have benefitted from a perceived lack of alternatives when it comes to asset allocation in a low-inflation, low-yield, low-growth world.
There looks to have been a possible link between the asset-buying schemes of the Bank of England, Bank of Japan, European Central Bank, Swiss National Bank and the US Federal Reserve and global stocks in the QE years, so it will be interesting to see if that link holds in the event of a bout of QT.
Central bank liquidity looks to have supported global equities – and now it is slowly being withdrawn
Source: Bank of England, Bank of Japan, European Central Bank, Swiss National Bank, Thomson Reuters Datastream, US Federal Reserve, FRED – St. Louis Federal Reserve database
Bond markets and fixed-income ETFs
Higher wages and costs would expose bullish profit forecasts and equity valuations, which would be further pressured by higher interest rates and QT that would increase borrowing costs and increase the burden of the globe’s huge debts.
That takes care of leverage and a sell-off in bond markets could do a lot of damage to liquidity, especially given the popularity of bond funds and especially bond tracker funds, or Exchange-Traded Funds (ETFs).
ETFs are useful tools, as they are cheap and can provide diversified access to a range of assets via just the one instrument. They also offer the prospect of liquidity as they are traded on exchanges.
But the bond market is not liquid. It is an over-the-counter (OTC) market and one where regulatory pressure is deterring banks from making a market or committing their own capital to facilitate trading.
If wages, broader prices and interest rates rise, that is a bad recipe for bonds, where lowly yields and coupons could be offset by both inflation and any capital losses suffered – since bond prices fall as interest rates go up. That could inflict a lot of pain on bond ETF holders who have either been seeking ‘safe’ yield from sovereign or investment-grade corporate debt or chasing yield from the high-yield or junk market and may find themselves unable to sell easily at the price they want when they would like to.
Hefty losses here could knock a hole in global liquidity flows, dampen investor sentiment and choke off appetite for the corporate debt which has been used to fund the share buybacks and takeovers which have helped to support stock markets.
A good proxy for bond-market sentiment is the iShares iBoxx High Yield Corporate Bond ETF. On the three occasions since launch that its price has dipped below $85 this has been a sign of growing financial distress and market unease (2008, 2011 with the Greek crisis and 2016 after the collapse in oil).
The ETF currently trades at $87 having traded in a very tight range throughout 2017 and it should be watched closely as a potential indicator for the arrival of a ‘Black Swan.’
High-yield bond ETF could be a good guide to market risk appetite in 2018
Source: Thomson Reuters Datastream