Over the last 5 months, the Nasdaq 100 (QQQ) is up over 36% against a rough macroeconomic backdrop, tightening liquidity conditions, and an already-elevated valuation landscape. The S&P 500 (NYSEARCA:SPY) has fared worse due to its exposure to financials, but the index is still up nearly 10% in that time as well. The same goes for Vanguard Total World Stock ETF (NYSEARCA:VT).
It appears, to us, that the market has been strong in the face of these issues for a couple reasons. First, momentum begets momentum. If a slowdown in rate hiking lit the match, then buyers have just been “going with it” since early this year.
Second, the explosion of AI has sent valuations for leading companies like Nvidia into the stratosphere (read more here). Nvidia (NVDA), Tesla (TSLA), Apple (AAPL), Meta (META), Microsoft (MSFT), Google (GOOG) (GOOGL) and Amazon (AMZN) have been responsible for the majority of index gains so far, which is of note.
Finally, and perhaps most importantly, there don't seem to be that many “big fears” right now in the market. Rates are already high and set to go higher. Leading economic indicators are weak and deteriorating in North America and Europe. So, perversely, in some ways the “worst has happened” and now we're just waiting to see how the economic data performs.
However, it did get us thinking. What kinds of risks exist out there that the market may be ignoring?
In this article, we'll lay out 9 of the biggest “Black Swan” risks on the horizon, and what you can do about them. Before you say “A black swan is a black swan because it can't be predicted”, then yes. That's true. But it doesn't mean you should be unprepared.
Number 1: China Invades Taiwan
Probability: 4 out of 10
We rate the possibility of China Invading Taiwan as higher than most.
In short, we believe that most western observers discount the level of national pride that has been built up in China over the last decade, and how “prepared” the country is to do this.
Regionally, China still faces a dilemma with the strait of Malacca, insofar as the majority of the country's energy imports could be blocked by the American Navy if tensions flare up. Additionally, the country is about to take a massive haircut on Belt & Road Initiative debt, which could seriously ding their domestic economy. As a result, the world's second largest economy may look to flex its military might to scare off rivals and add Taiwan's highly productive capacity to its own.
This would have massive global consequences as it would likely result in direct conflict between China and the United States. All it takes is one miscalculation or miscommunication to begin a massive global war. Right now, there are sufficient counterbalancing risks for China that should prevent such an engagement, such as a risk of encirclement, but if the calculus changes, then things could worsen.
The only real way to reduce exposure to this risk is by reducing Chinese equity exposure (FXI). If a war does break out, we think Chinese stocks are likely to suffer the most.
Number 2: Ukraine Escalates
Probability: 2 out of 10
We believe that the war in Ukraine is likely to drag on for years and ultimately end with a treaty of some kind.
However, it's possible that Russia or the west could miscalculate, and nuclear weapons could be unleashed. We don't see this as very likely, but Russia has made costly errors before and it's not immune to making them again.
If Putin's political grip on Russia becomes even more tenuous, or there's some accident (the Russian Military is highly corrupt and most of the equipment has been stripped), then all bets are off.
Reducing exposure here means buying seeds, a solar panel, and some fresh water supply. If nuclear war breaks out, the price of your favorite stock won't matter. If somehow a nuclear conflict remains regional, then CEE would likely see the worst of it.
Number 3: Pakistan Collapses
Probability: 7 out of 10
Pakistan has a number of massive issues.
First off, the country isn't competitive on any global market, and it remains a large importer of almost all goods, including food, finished goods, and technology. The problem with this is that the country is running out of foreign currency reserves at a rapid rate.
Other issues include a massive international debt pile the country can't pay back, a horrific flood which caused nearly $50 billion dollars in damage to a country whose annual GDP is less than 10 times that, and a non-zero chance of a civil war due to political issues surrounding Imran Khan, the country's former leader who was just jailed by the military.
Plus, it's a nuclear-armed power.
In our view, Pakistan remains the single largest source of global instability right now.
Reducing risk here means backing away from Indian Equities and purchasing defense stocks. In the past, we have advocated for Indian exposure, but given the proximity it's difficult to see how Indian equities wouldn't suffer as a result of regional instability (INDA, SMIN).
In a war, defense stocks should do well as western militaries may end up getting entangled. (LMT, GD, RTX)
Number 4: Banking Instability
Probability: 8 out of 10
While the recent regional banking crisis remains fresh on everyone's minds, the real issue with the global banking system is that it works until it doesn't.
Every few years, someone takes a risk they shouldn't, or there's a systemic risk so big that everyone gets nervous that the whole system will fail.
This happened recently, and the Fed changed up the rules to protect SIVB depositors, which it had no obligation to do, simply so that panic wouldn't spread. The result is perverse incentives for banks, who are likely to miscalculate further at some point down the road.
There are no issues right now with banking stability per-se, but given the leverage in the system, there's always a risk of things going bad at any time.
The way to reduce these risks is straightforward: reduce bank exposure and add gold miner exposure. Alternatively, one could add gold (GLD) itself.
Number 5: Kashmir Escalates
Probability: 3 out of 10
Kashmir is likely the most contested border in the world today, aside from Ukraine.
The region sits directly in the middle of northern India, northeast Pakistan, and western China. Given the region's strategic importance, water resources, and cultural significance, it's likely that the conflict there will remain warm for a long time to come.
Currently, the border sees frequent skirmishes between Indian, Pakistani, and Chinese soldiers, but should things heat up, for whatever reason, then the world has 3 nuclear-armed powers essentially at war in very close proximity. It's not hard to see how that could get out of hand and disrupt global markets.
Reducing risk in this context means reducing Indian and Chinese equity exposure. (INDA, FXI)
Number 6: Central Asia Destabilizes
Probability: 9 out of 10
As Russia's role as regional policeman fades, frozen conflicts in central Asia threaten to spark back up, especially between Azerbaijan / Armenia, and Kyrgyzstan / Tajikistan.
While likely, and horrible, these are unlikely to affect markets much, as central Asia produces very little economically. They become more relevant should larger powers take notice or attempt to get involved in some way.
There's no action to take to reduce these risks, unless you live in any of the aforementioned countries.
Number 7: Egypt Collapses
Probability: 3 out of 10
Egypt is a country with a livable area the size of the Netherlands that boasts a larger population than Canada and Italy combined.
With a lot of mouths to feed and not much arable land to feed them, the Nile River delta is set to become one of the most unstable regions in the world in the coming years due to crop and water shortages, global grain supply chain issues, and regional conflict.
As a massive food importer, the country risks becoming a de-facto vassal of a country with better terrain, like Turkey.
There's also the conflict over Ethiopia's new Renaissance Dam. In short, the dam threatens put Ethiopia in control of the Nile, a critical water lifeline to Egypt's more than 100 million inhabitants. This is something Egyptian planners simply can't tolerate. (more here)
The Egyptian army has plans to terraform some of the country's unusable land and has threatened Ethiopia to prevent water supply issues, but the jury remains out on whether or not any of this is possible.
Reducing exposure to Egypt (EGPT) seems prudent in any case.
Number 8: Inflation Re-Inflates
Probability: 2 out of 10
Inflation remains the persistent monetary problem of modern society.
Too high, and people's quality of life gets worse. Too low, and it doesn't encourage any productive activity.
The trick with inflation is broadly that more money is needed to accommodate for a larger, more productive economy, so that people who have had wealth historically don't see their buying power improve as a result of the work of others (this remains Bitcoin's problem).
However, if too much money is printed, or supply chain snags hit an economy, then things destabilize, and people get hurt.
Right now, we are in the “cooling” phase of the cycle. The economy is slowing as a result of higher interest rates, the supply chain is improving, and prices are coming down.
However, inflation is somewhat psychological as well – it can't be fully accounted for in economic models. Thus, if inflation rises again without the fed cutting rates, then a lot of assumptions about asset prices made over the last year are wildly wrong and the market could see a huge correction.
Exposure wise, we don't see this as likely, but it is worth keeping an eye on.
Number 9: Large-Scale Terror Attack
Probability: 10 out of 10
To us, it seems extremely likely that a large-scale terror attack of some kind will likely affect a major western city at some point in the future.
There's really no way to position around this happening, and it's hard to detail the impact on markets without knowing what the event is.
However, it's always good to be aware of this fact, so one can be quick to react if/when disaster strikes.
Summary
Well, there you have it! 9 risks that we think you should be aware of, in a broader macro sense. Did we miss any? Let us know in the comments.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.