Black Swan Events

In the financial world, Black Swan events are extremely rare events that can cause cataclysmic reactions. The 2008 financial crisis was a black swan.

A black swan is rare in nature, as nearly all swans are white. Hence, the parallel to nature. Black swans are truly dangerous because the financial system doesn’t properly hedge for this type of rare event. They use probability to drive their hedging strategies. And the 4 or 5 sigma event isn’t accounted for.

Black swan events are supposed to be rare – like once in a century – event. But in modern times they’re increasingly becoming common. The 2000 internet bubble was one. The 2008 housing debt crisis was another. And it’s precisely 8 years later now in 2016.

The reason why black swans are no longer driven by statistical patterns is because of the extremely abnormal amd active policies our central banks and goverments are engaged in. It makes natural economic phenomenon unnatural, distorted. And global debt is at atronomical highs, and increasing. This causes sensitivity to all kinds of slight movements having the potential to create another black swan.

And, like in 2008, new extremely dangerous derivative financial instruments create more hidden risk than ever before. These tools are meant to provide safety and insurance, supposedly – ironically – to create systemic stability. But we discovered in 2008, the opposite is true. Think of derivatives, like CDS or credit default swaps, as insurance. If an investor or company buys government or private company debt, and if they are concerned about bankruptcy and not getting their money back, they buy these CDS’s for pennies on the dollar, as an insurance policy. If the entity goes bankrupt, and the bonds become worthless, they get paid full value.

The problem is only a few companies write these derivative contracts. And there are literally hundreds of trillions of dollars of such derivatives in our world today. Furthermore, since this is completely unregulated, it creates hidden systemic risks. These tools increase the chance of a black swan event exponentially.

Today, due to the incredibly complex interrelationship of our global financial world, it’s difficult to determine where the next black swan will come from. But I decided to list the likely causes and what I think will precipitate the next black swan crisis. It will happen, as sure as the sun will rise. It’s only a question of how soon. When you have this much global debt, these many fancy financial derivatives, lack of transparency and regulation, coupled with greed driving over-leverage, it is as certain as the sun rising in the east and setting in the west.

Let’s be clear, it is inevitable; no matter how much we want to refuse to believe this is possible.

So, here is my incomplete list. Many of these are inter-related:

1. Currency gyrations. Due to central banks’ intimate micro-management of economies, currency gyrations are at historic highs. They far exceed 3 sigma day to day movements. This is the normal now. Anytime this much volatility is suddenly happening, you should be careful. The fact that currency movements are so fierce and rapid nowadays, when throughout history, even 1% per day was considered very extreme, tells us there is instability in the system. Nowadays we get 1% movement all the time, and major currencies can shift 10% in a matter of a month or two. Fed and central bank policy, QE and ridiculous interest rates are the reason. When the dollar is too strong, it could precipitate a global economic calamity, as other nations start to suffer economically and defaults soar. Nowadays there is just too much dollar denominated loans in foreign countries, especially emerging economies. About $9 trillion by some estimates. When the dollar rises 20-30% versus a currency, it makes repayment proportionally higher, and at a time of a poor economy and struggling companies who can no longer refinance their debt in the bond market, due to higher risks and rising rates. Imagine if everyone’s home mortgage payments suddenly went up by 20-30% in a short time? How many defaults and foreclosures would there be? Oh yeah, that’s what happened in 2008.

2. Emerging markets collapse. The mutli-decade insatiable demand of all commodities, primarily out of China, created a global growth story for every country that exports raw materials and commodities such iron, gold, lumber, wheat, corn, oil, and so much more. These countries became addicted to high growth thinking it would last forever. They’re goverments started overspending as tax revenues skyrocketed. People and businesses took out all kinds of loans. Much of it in dollar loans. Even industrialized countries like Australia, Canada, and Norway saw a huge impact to their growth. Both Canada and Australia had currencies – only a few years ago – that were much stronger versus the dollar, due to this commodity boom. Today, these currencies have devalued by about half relative to the dollar. Countries such as Russia and Brazil and many other emerging countries have seen massive slowdown economically and are also seeing massive depreciation of their currency. Russia is down dramatically, with the dollar rising over 150% in a few years. Brazilian real is down also, with the dollar up 100% in the same time. You can’t have these types of movements, on the scale globally as we have, and not expect bad things are going to happen in our interconnected world! Not when trillions of loans are at stake. People often say, well nothing’s happened so far, so you must be wrong. These things take time to build up. It’s like a volcano. A volcano doesn’t erupt suddenly because the pressure became unbearable overnight. It was building for a long time. And likewise, these countries, the economic consequences, take several years. But when they start, it impacts us too because everything is interconnected. Our American banks and European banks are on the hook for trillions of dollars and euros of loans to these failed states amd companies. It is impossible they will pay these loans back given their condition.

3. China. Everyone talks about China, but usually for the wrong reasons. When the stock market starts collapsing, everyone suddenly panics and pays attention. The important stuff is not the stock market. It’s the bond and debt market, and currency. China has amassed more debt faster than anyone else in history, by a long long shot. $28 trillion is hard to spend in less than a decade (most of this debt was since 2007). These debts take time to impact the financial markets. But it’s clear, Chinese company’s profit margins are putrid, abysmal. The overwhelming majority are losing money. The government run companies and banks are losing the most money. And yet they have unimaginable amount of debt on their books. The banks have so much bad loan debt, if they were in the US, they would officially be bankrupt or out of business. Or bailed out by our government. But the amount Beijing would need to inject into the banks and companies is in the trillions of dollars, perhaps tens of trillions. It makes our 2008 bank bailout seem like small change. This fundamental weakness in the Chinese economy, and the severe strains this toxic debt is causing, is forcing the economy to slow, and the yuan currency to weaken. It will weaken a hell of a lot more. And Beijing is powerless to prevent it for more than a few months. And this feeds back into the stock market; and stocks will decline much further, even from here. Stocks are already down over 40% from the peak. They must decline AT LEAST another 50% from current levels. This would bring the Shanghai composite to 2000, which is closer to fair value. I think somewhere between 1500 to 2000. All of this is due to the incompetence of the communist run central government. A few goons can’t simply dictate where this much money should go without bad consequences and inefficiency. Beijing first decided to build massive new cities to house hundreds of millions of new urban dwellers. They built new roads and highways and railways and airports in a matter of a decade or so. They fanned the flames of a housing bubble. They intentionally wanted to create a stock market bubble to create wealth and a larger middle class to transform their economy into a consumption and service oriented economy, away from cheap manufacturing. But this type transition takes decades. Beijing, like everything else they have planned, tried doing this in a few years. It backfired. Not surprisingly. Today, we have a stock market bubble that has collapsed, and still collapsing. We have a real estate bubble in the early stages of collapse. They have huge empty cities called ghost towns. And so much debt in the system it’s clogging everything up. All of this is now unwinding. And yes, this absolutely matters to the entire world. Just as our 2008 financial debt crisis affected the world. Except China’s situation is much bigger, much worse. I saw an article the other day. The author was explaining how what’s happening in China shouldn’t matter to us. And I thought, did this guy graduate high school?? Is he a plumber trying to pass off as a financial expert?? It matters a hell of a lot. It should terrify everyone.

4. War. Major calamity. No need to elaborate. There are many geopolitical risks. Wars are normally bullish, but today’s world, it could be disastrous. For instance, imagine terrorists shut down part of most of our power grid.

5. Oil collapse and the commodity implosion. It started over a year ago. When China stopped spending trillions on building new cities and vast infrastructure, the commodities demand needed for this activity dried up. All commodities started a massive decline over a year ago. It imploded a bunch of commodity based countries as I mentioned. The demand for commodities will never return as it was. Never. The China story is a once in a hundred millenia type of growth story. The world needs to recalibrate to this new reality, this new paradigm. What this portends is that global growth will be far slower, on average, over the coming decades than the previous century. In a world of slowing intrinsic growth, and historic huge debts, that is a terrible combination. It stresses the ability to repay this debt. If you saw a chart of global debt since 1970, you would drop your jaw. And the ridiculous thing is that the 2008 financial crisis, caused by excess debt, now looks responsible compared to today’s debt levels. We solved one problem, avoided global meltdown, by creating even more debt, faster. We “solved” the debt problem by adding a bigger mountain of debt. Truth is, we didn’t solve anything. We just delayed the economic pain. And created a much bigger problem that we will have to deal with soon enough.

6. Europe sovereign crisis. The European crisis is not over.  As the southern European countries have grown ever so modestly, the media attention and financial panic has gone elsewhere. But the continent unemployment rate is still ridiculously high double digits. Youth unemployment is absurd and in many countries 50-60%. This itself is creating severe social problems down the road. We are sowing the seeds of leftist philosophy – even communism – allowing them to creep back. The European sovereign crisis is, in some ways, much worse now than before. The debt to GDP levels are worse than before. Ok, Greece is slightly better only because they restructured some debts. But it’s still unrepayable. The problem was a slow economy coupled with a huge debt burden. As China and the emerging economies continue to slow, the effects will eventually reduce Europe and US growth rates. And once again, the slow growth plus huge debt problem will resurface, but with a vengeance, given the even higher debt piles.

7. Interest rates go up more rapidly. The world has been in a happy state for 7 years with zero rates. Inflation is low so this isn’t such a problem. But employment, at least in the US, since US rates are most critical and drives the value of the dollar, is already full. Wages are finally moving upward a little faster,  but the trajectory is concerning. Wages are the number one component of inflation. Oil price are at $30. This is about bottom. It may get into the 20s briefly from panic and momentum, but roughly speaking, oil around $30 is close to a bottom. If oil prices spike for some reason, perhaps Saudi Arabia finally decides to cut production to increase prices and profits, perhaps a terrorist event, perhaps a major war in the Middle East between Saudia Arabia and Iran or the West. Anyway, the deflationary components are at or near bottom. So this means inflation can only rise from here, likely. Inflation is only slightly below 2% now, which is the Fed’a target. If inflation rises to say 2.5% – 3%, which is still modest, it forces the Fed’s hand to quickly raise interest rates to a more normal level – not zero. The bond bubble is the greatest bubble in human history. Because the bond market is bigger than the stock market by far. And with record low zero percent, bonds have been priced to perfection. If rates rise quickly, surprising Wall Street, bonds will fall dramatically. This will have a knock on affect to every other asset. Banks hold lots of bonds because they’re supposed to be safe. So if their safest asset plunges in value, it changes their leverage ratios. They must sell other assets to manage risk. It’s a self-feeding spiral. And the concurrent selling by all investors and banks would be the problem. It could easily spread and collapse every bubble simultaneously. Tens of trillions of lost wealth within days. Perhaps hundreds of trillions.

8. Derivatives. We talked a bit earlier about derivatives. The problem is that this entire market is unregulated and nebulous. By some accounts, the global derivatives market is over $700 TRILLION. That’s nearly 10 times bigger than the entire global economy. If this doesn’t scare you, it’s only because you don’t understand the potential danger, or you’re a rebel and just don’t give a shit about much.

Derivatives are like insurance, as I mentioned. Normally insurance companies are highly regulated by governments. And they are required to hold large cash reserves in case of an emergency and large payouts are required. But since this is the financial industry, with cozy ties to Washington (all those political donations and personal relationships coming in so handy), there is no regulation. The main reason is that banks want to hold as little in actual cash reserves as possible. Just the opposite of what is required of insurance companies. This is because banks make money by leveraging. So if they hold 5% cash and leverage the shit out of their assets, they can make billions. And they do. The problem is if defaults hit, and those derivatives come due, they don’t have the cash to pay their legal obligations. So they have to sell assets. Unfortunately, this type of scenario will occur during distressed market conditions. So banks must sell at the worst possible time, likely in a crashing market. They will get poor prices. This creates more losses. And the negative feedback loop continues. This is precisely what happened in 2008 after the Lehman bankruptcy situation. Assets became illiquid, meaning nobody wanted to buy them. So banks couldn’t get reasonable value. And they simply ran out of cash. You would be surprised how little cash a bank with trillions in assets on their balance sheet actually carries. The entire system is perfectly idiotic. It’s all setup to drive tremendous profits in good times, and if shit hits the fan, the shit will just be flung everywhere. It’s ugly.

So, these are the primary black swan risks I see. Sadly, all of these events seem to be converging at the same time. They are related but independent events. Each could derail the global financial system. And yet, it seems most likely they will overlap in effect.

These are scary times indeed.

It’s true I may not get the timing of these events with precision. Nobody can tell  with certainty exactly when. Maybe I’m off by a few years. But make no mistake, I cannot be wrong here. That is an impossibility. Not because I think I’m infallible. But because the facts say otherwise, and the narrowing window of escape keeps getting tinier and tinier. And some point, you reach a condition where there is no move you can make to escape utterly traumatic consequences. It’s like when you’re playing chess, and no matter what moves you make, checkmate in 3 steps is the best case scenario.