- We’ll discuss the most obvious risks to the current financial environment.
- For example, higher interest rates are already negatively affecting the U.S. economy and inflation.
- However, the most dangerous risks are the hidden ones.
Yesterday we discussed the main factor behind the current bull market, i.e. central bank asset purchases, and I described three potential scenarios, one where things continue as expected, one where central banks increase stimulus, and one where inflation messes things up for everyone.
Nevertheless, nothing that was discussed in yesterday’s article was a new finding. Such fears have been circulating the financial environment since 2009, and as we have witnessed, nothing much has changed since then while the global financial system seems stable as a rock. Even Japan’s economic activity has surprised on the upside with growth of 4% for Q2 2017.
The most important thing to assess now is the sustainability of the current economic environment. If the economic environment remains as is, then you know what to do. Stick to assets that work well in such environment, i.e. stocks and bonds. But, what if things suddenly change?
A look at the actual risk that things might change could help in approximating the weights to attach to potential portfolio hedges to protect yourself form the unexpected.
Risks To The Current Financial Environment
The funny thing with investing risk is that you never know how big it really is until something bad actually happens. Investing in stocks in the past 8 years turned out to be the best option, but we’ll never know the risk these investments carried as they never materialized.
The same is true for potential future risks. We can discuss them, but we can’t know which one will, and when it will, materialize. This makes investing a very complicated activity, especially if you want to protect your portfolio. Don’t be fooled by recent investing success because investing performance has to be measured over at least a cycle and we have seen only a booming economy for the last 8 years.
Another interesting thing is that many risks are hidden, i.e. black swans. Some things may look robust but can become very fragile in no time. However, we can only discuss the obvious and the best place to start is the Oxford Economics Global Risk Survey.
Figure 1: Global financial risks. Source: Oxford.
One of the largest perceived financial risks is U.S. policy errors. As nobody knows what kind of impact the monetary easing we have enjoyed in the last 8 years will have in the long term, that’s exactly where the risk lies.
The FED has announced that it will start to trim its balance sheet and it has increased interest rates. The first impact of such actions can already be seen as U.S. car sales declined 7% in July when compared to the same month in 2016.
Higher interest rates make it more expensive for people to own a car, which first leads to lower sales, then inventory build-ups, and, if not resolved, to layoffs, etc.
Figure 2: U.S. light vehicle sales have been declining since the FED started with tightening. Source: FRED.
If such small rate increases already have such a significant impact on a part of the economy like the auto industry, we can only imagine what a too aggressive tightening policy would do the economy. As it’s clear that this is a credit economy that we live in, the FED’s task to keep things stable with low unemployment is really very delicate, and one where it’s easy to make mistakes. For now, things are going well, but you never know when things can change, and that’s why it is a risk.
I’ll skip commenting on North Korea as that’s a political issue and I really hope it turns out for the best because a war wouldn’t help anybody.
The third potential risk comes from a downturn in China. Fortunately China continues to grow, but a downturn would have a global impact.
If you take a look at the figure below showing the factors creating U.S. inflation, you can see that the spur in inflation we recently had is mostly thanks to higher energy prices.
Figure 3: Higher energy prices have increased inflation. Source: IIF.
If China slows down, global demand for commodities would also decline and inflation would quickly turn into deflation, as was the case in 2014 and 2015.
The third possible risk is a bond sell-off. The issue wouldn’t come from actual bond sales, but rather from higher interest rates which would heavily weigh on many highly indebted corporations and especially countries. Countries with high debt to GDP ratios like Spain, Portugal, Italy, and Greece, would come under extreme pressure if interest rates increased. For those countries not to default, interest rates must remain at current historical lows.
Figure 4: Spain’s government debt to GDP ratio. Source: Trading Economics.
The risks described above are the obvious ones, but history teaches us that the hidden risks are even more important as an unexpected shock hits the economy much harder than an expected one. We’ll see which risk will materialize itself and how global policy makers will react to it. Unfortunately, it’s impossible to know when a risk will materialize and what the will be impact.
Conclusion & Portfolio Positioning
The portfolio related issues with the above risks are that these risks could materialize themselves tomorrow or not show up for the next five years.
For example, if you protect yourself against inflation and further central bank money printing and that doesn’t materialize, you would incur a loss and on top of it, a pretty significant opportunity cost. However, this is a necessary trade-off between mindless investing and risk adjusted investing.
Keep reading Investiv Daily as we’ll soon discuss a practical way to build an all-weather portfolio that should perform well no matter what happens. We’ll also discuss gold royalty companies and their risk reward perspective in the current financial environment.