Global Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

February 21, 2017

Peter Donisanu, Investment Strategy Analyst

Be Prepared for Black Swans, Fat Tails

  • Global risk assets have exhibited positive performance during the first few weeks of 2017, on the back of improving global economic conditions.
  • While we continue to expect favorable economic conditions to be a positive contributor to risk-asset rallies this year, we caution investors to expect the unexpected.

What it may mean for investors

  • Uncertainty poses risks as well as opportunities for investors. We believe that investors are best served by preparing to weather unforeseen outcomes rather than attempting to time them.

Risk assets, including global stocks, high yield bonds, and commodities, have rallied during the first few weeks of 2017. We believe that a general improvement in the global economic outlook for the year has underpinned the recent rally in risk assets. Indeed, at this time last year, a key concern (and one that precipitated a sharp market selloff) for some financial market participants, was whether a sudden slowdown in China’s economy would bring global economic growth to a halt.

Chart 1: A Generally Favorable Economic Outlook has Underpinned Risk-Asset PerformanceChart 1: A Generally Favorable Economic Outlook has Underpinned Risk-Asset PerformanceSource: Wells Fargo Investment Institute, Bloomberg; 2/17/17

The base-case scenario of a China-induced shock to the global economy that some financial market participants expected to occur in 2016 ultimately failed to materialize last year. However, British voters’ decision on June 23 to leave the EU (Brexit) and Donald Trump’s presidential campaign win were outcomes expected by few observers.

The latter two events have each been described as a black swan, or “an unpredictable or unforeseen event, typically one with extreme consequences,” as defined by the Oxford Dictionary. These two events could also be characterized as “fat tail” events, a term used to denote an outcome’s low statistical probability of occurrence when measured over a broad distribution of historical observations.

Potential Black Swans, Fat Tails

While financial markets took the unforeseen outcomes in stride last year, we nevertheless believe that investors should be positioned for other potential unexpected events in 2017. In our opinion, sources of black-swan or fat-tail risks are likely to emanate from Europe, China, and the U.S. this year.

Europe faces elections in the Netherlands, France, and Germany—along with renewed uncertainties surrounding Greece’s ability to renegotiate terms of its mounting debt load with its creditors. These events are set to play out between March and the end of 2017 and could culminate in a black-swan outcome (fracturing of the EU). The rise of Eurosceptic governments in France and the Netherlands, along with Greece’s inability to further service its mounting public debt, could bring into question the European Union’s ability to persist as a going concern.

The potential for policy missteps in China are elevated as the rate of non-performing loans on bank balance sheets continues to climb. While a credit-related economic shock failed to materialize in China last year, there is still potential for a fat-tailed event to occur this year and beyond. While not part of our base-case scenario, we believe that the circumstances surrounding such an outcome would include policymakers in Beijing taking an aggressive role in restructuring inefficient state-owned enterprises or allowing credit defaults to occur in greater frequency.

Finally, policy missteps in the U.S. could also lead to an outcome with extreme consequences. In a policy paper published in June 2016, U.S. Representatives Paul Ryan and Kevin Brady proposed a border-adjustment tax (BAT) as part of their broader U.S. tax policy reform. While President Trump has not officially endorsed the policy proposed by these members of Congress, the President has recently indicated support for a broad border tax. International outcry against a proposed BAT could, if pushed through without much consideration, lead to retaliation by international trade partners.

Positioning for Unexpected Outcomes

We believe that the black-swan events described here have a low likelihood of occurring, but nevertheless believe that investors should be properly positioned in case of a fat-tailed (low probability) outcome. We suggest that investors employ prudent portfolio-management strategies that include aligning their strategic asset allocation with their long-term investment goals. We also recommend rebalancing by bringing portfolio allocations in line with strategic objectives, while adding and trimming allocations as favorable market conditions present themselves.

While concerns about unpredictable or unforeseen events are likely to rise during the year, we believe that uncertainty poses risks as well as opportunities for investors. We recommend that investors seek to exploit price drops in markets as entry points for favorable investments. We also suggest that investors avoid trying to time the equity markets, particularly as it relates to events surrounding the Europe, China, or U.S. trade policy, as being out of the markets at the wrong time can be costly. As such, we believe that it is important that investors look through the uncertainties related to these events and remain fully committed to and fully invested in their long-term investment plan.

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.

Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks.

Investments in fixed-income securities are subject to interest rate and credit risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Definitions

Bloomberg Barclays Global High Yield Index measures the performance of the global high yield bond market.

Bloomberg Commodity Index is a broadly diversified index comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

MSCI AC World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 46 country indices comprising 23 developed and 23 emerging market country indices.

An index is unmanaged and not available for direct investment.

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC (WFCS) and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

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