This last year brought us many surprises as several countries chose to make significant policy changes. As the new year gets underway, many of these changes will begin to take effect in the world consequently impacting the global economy. As the markets respond to these changes we watchfully wait to see whether these changes will be for the better.
2016 started off with a major downswing due to oversupply in the oil markets and unease in China. Since then, both markets have seen dramatic changes. OPEC finally got together and offered a promise to reduce supply, but already some doubt has crept in regarding whether they can keep all the various players in line. China has changed its currency peg from the dollar to a basket of currencies.
The United Kingdom voted to leave the European Union and now begins a bumpy journey. Fears remain as to what effect it might have on the British economy. The US has also taken a step towards protectionism with the election of President Trump and will begin a transition towards being more inwardly facing this year.
Europe continues to try and fight off slow growth and is beginning to explore more fiscal options as monetary policies come to a close. However, issues such as immigration and tension with Russia continue to make any decision difficult.
These major events are leading to what is referred to as an increase in “tail-risks.” Generally, the more extreme ups or downs of the market are considered unlikely events and are at the far end of the probability spectrum. However, with massive changes comes an increased likelihood of more extreme results. The downside risks include rising debt, central banks exhausting all options, and populism leading the world to decreased cooperation. The upside could come from deregulation and pro-growth strategies, simpler tax codes, and stimulative fiscal policy.
The question in front of us then is how do you invest in a world of potential extremes? The first place to start is with expectations. The road will most likely be bumpy with both under- and over-reaction to the news. Patience will be incredibly important as it takes time for the markets to digest what is happening. Furthermore, it becomes increasingly important to be appropriated allocated especially with defensive assets (typically bonds). Bonds continue to provide an anchor during storms of volatility and it is important not to lose sight of that if things get choppy. Opportunities will come especially during over-reactions, and entering the storm with a solid base will make it easier to take advantage of those opportunities.