photo by Tanya Syrytsyna

This article appears in the January 2022 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

The United States and China escalate trade disputes — or worse, go to war. Politicians heavily penalize greenhouse-gas emissions. Hackers cause major electrical power disruptions. These are among the potential low-probability but high-impact events keeping some Canadian economists up at night.

A conventional shooting war between two superpowers is one potential economic “black swan,” said Jimmy Jean, vice-president and chief economist with Desjardins Group.

In addition to human suffering, a major military conflict among superpowers could lead to a general sell-off due to concerns regarding widespread property damage, increased government borrowing and possible tax increases, plus major supply-chain disruptions in a globalized world. However, defence- or reconstruction-related securities could see gains, Jean said.

There could also be “the possibility for some of the protagonists to gain control of vital commodities, and general uncertainty about what would be the outcome of the conflict and what kind of world order would ensue,” Jean said.

A conflict between the U.S. and China also could involve a major trade or industrial dispute, suggested Sébastien McMahon, interim chief economist and senior portfolio manager with iA Financial Group. He cited the controversy concerning China-based telecom equipment maker Huawei Technologies Co. Ltd.

At the time of writing, Canada was the only Five Eyes intelligence pact member yet to announce a decision on whether Huawei products will be allowed in fifth-generation artificial intelligence-based telecommunications networks. The four other members — the U.S., the U.K., Australia and New Zealand — have banned or restricted Huawei’s involvement in their networks. Such restrictions could lead to retaliatory measures by China, potentially harming firms exporting to the country.

“We may politicize companies and politicize technologies. At some point, this creates some real-world issues and some market issues,” McMahon said.

But a black swan could involve other conflicts. For example, it “could also be something more 21st-century, like a highly disruptive cyberattack that [could] cut the power supply,” Jean said, noting that hackers have already attempted to disrupt Canada’s electrical grid.

Jean added that a major power-supply disruption arising from a hostile state actor “could cause a massive surge in commodity prices and inflation, at least at the outset.” This in turn could cause investors to lose confidence in the IT sector, due in part to the fact that investors could be concerned that cybersecurity products and services are not as robust as originally thought.

“If we’re in a world of lost trust in everything that’s carried out online [and] on smartphones, et cetera, [that] could imply a big decline in productivity as we fall back to less efficient ways of doing business. That would be negative for big tech, but also for the economy as a whole,” Jean said.

Another possible black swan is a major weather catastrophe that raises concerns about the impact of climate change.

“[That] would be a highly, highly disruptive weather event — say, a major flood that hits a sensitive economic region of the world,” Jean said. “That would have governments saying, ‘Enough is enough. We have to curb our [greenhouse-gas] emissions fast and now.’”

Jean added that such a catastrophe would be much more severe than the 2021 floods or wildfires in British Columbia.

A resulting government backlash against greenhouse-gas emissions could be bad news for oil and gas stocks, but good news for environmental, social and governance-based funds, Jean said.

But black swans, by their nature, are difficult to predict.

“I think the past couple of years have shown us it’s a fool’s game to try to predict those type of events because they often don’t play out, and it’s something that you are not aware of,” said Macan Nia, co-chief investment strategist with Manulife Investment Management.

“What is in the headlines is unlikely going to be the biggest risk to a client’s portfolio,” added Kevin Headland, Manulife’s other co-chief investment strategist.

The most probable near-term risk to investors, they said, is a recession.

Central banks could overreact to inflation statistics by raising interest rates too far too fast, McMahon said. “If we have central banks overreacting, we could have some monetary policy mistakes, especially if inflation is more short-term than what many people are expecting,” he said.

But recessions are only called after we’re already in one, so Headland advised investors to watch for leading indicators, such as a slowdown in housing starts.

“You don’t want to wait until a recession to reallocate your portfolio, just like you don’t want to wait until you are caught in a storm to put up your umbrella,” Headland said. “You want to look at what the forecast is for the weather, just like you want to look at indicators for the economy.”

Nia said investors with a high allocation to stocks could “pare back a little bit of that equity exposure” in the event of a recession. In particular, a client who owns “growthy” or cyclical equities could reduce their risk by moving to equities that are considered more defensive, he said.

Another major short-term risk is what McMahon described as a “highly speculative environment” combined with young first-time investors who have never experienced volatility in their portfolios.

Those investors “started to appear in 2020,” McMahon said. “They had never tasted real volatility. What will happen to this crowd of new retail investors when they do have a real bout of volatility and they take some real losses and they all run for the exits?”

But sell-offs of this kind could be good news for value investors: shares in some solid companies could become undervalued, McMahon added.

In the unlikely event of a black swan, Headland advised against making knee-jerk reactions to what could be short-term movements. And do not convert an entire portfolio to cash.

“The problem of going to cash or selling out is it takes two decisions,” Headland said. “First, when to get out. Secondly, when to get back in ­­— and the getting back [in] is often the most difficult decision.”

This is because it is almost impossible to figure out when the market has hit the bottom, which investors learned in the early days of the Covid-19 pandemic.

“Who would have called March 23, [2020] as the bottom of the market?” said Headland. “The market went down 35% and people were saying, ‘It’s going to go down 50%. I got out and I’m going to wait.’’’

Investors who respond to a black swan by cashing out often are “going to wait for the next shoe to drop, the next drawdown [or] the next bear market to get back in,” Headland said. “And what happens is a bull market starts and it never lets you in. So you miss some great opportunities along the way.”