How many times have you heard "we never saw it coming" after a major crisis that, in fact, many people did know was looming? These are the obvious but unresolved dangers that I call gray rhinos: big and neglected, willfully or not. In contrast to a highly improbable black swan, a gray rhino is both predictable and likely. But the outcome is not a given.
Predictions may be imperfect, but we do have tools at hand to help us think about what developments are most likely to sideswipe our plans. Every year, analysts compile lists of top risks for investors and policy makers: the World Economic Forum's Global Risks Report, political risk consultancy Eurasia Group, the Council on Foreign Relations Preventive Priorities survey, the Economist Intelligence Unit's Global Forecasting Unit, the Allianz Risk Barometer, the PWC CEO Survey, Deloitte's European CFO Survey, and HSBC's top risks, and a good number of individual analysts. Other reports from the International Monetary Fund, Bank for International Settlements, and Institute of International Finance complement them.
Each list has its own focus and slant. Combined and filtered, they make for a strong comprehensive list of gray rhinos. Much as the site FiveThirtyEight does for poll results, this approach provides a wider, balanced, global view of the year's top risks than any individual ranking can on its own.
Most of these lists appear in the first quarter. In the months since, the momentous Brexit vote, conclusion of the U.S. primary season, and evolving economic picture make it worth revisiting them as the summer winds up and markets head into the typically volatile last part of the year.
The Top Five Gray Rhinos of 2016 are listed here in order of importance, based on the frequency and rank of their mentions earlier in the year. I've updated each with my view on how the outlook has evolved over the course of the year.
1) Deepening fractures within the European Union: Brexit panic makes it both more crucial and more difficult for the EU to address structural economic imbalances between richer and poorer members, which in turn have worsened social and political strains that threaten the euro area. The refugee crisis followed by the terrorist attacks in Paris and Brussels, mainly perpetrated by native-born European minorities, deepened stresses that already were rising as politicians muddled. Further restrictions on movement across borders within the EU could cost a full percent of GDP. Though markets quickly recovered from the immediate post-Brexit body slam, there's much more to come. Brexit raises the stakes in Greece's ongoing debt drama, in Euro-skeptic nations like France and the Netherlands, and in countries like Italy, with a growing bank crisis of its own ahead of a crucial referendum. EU policy makers not shown convincingly that they are addressing the continent's security and economic fears. The one hope, intensely rose in color, is that this crisis creates an opportunity that should not be allowed go to waste -for the EU to make significant steps toward the political and fiscal coordination that policy makers have long know was essential for the monetary union to function. Upshot: EU risks have risen sharply since the beginning of the year.
2) Financial market liquidity shocks: Central bankers have been wrangling two gray rhinos charging at each other: the failure of monetary stimulus to create growth and deter deflation, versus the role that loose monetary policy has played in distorting markets and hurting savers even as it becomes less and less effective. Emerging markets are vulnerable either way, whether interest rates rise or if the global economy remains weak and thus commodity prices stay low. U.S. corporate debt levels and giddy stock prices are flashing warning signals. Brexit related market shocks feed into volatility, alongside oil market gyrations and China's rising debt and slowed economy, combined with currency pressures. Each one of these interrelated risks could create a major domino effect should it fly out of control. Worries about oil prices and the Chinese economy have ebbed since the beginning of the year, but have not gone away. Improving U.S. economic numbers suggest that deflation risk is falling. But while many investors will welcome the resulting opportunity to normalize monetary policy, rising interest rates could have unintended consequences in an unstable system. Upshot: the potential for liquidity shocks has risen modestly.
3) U.S. political instability and rising nationalist populism: The intensifying polarization of United States politics, including deep divisions within both major parties, has paralyzed its ability to make decisions as simple as approving urgently needed aid for Puerto Rico to fight the Zika virus and hurt investor confidence in economic policy. The likelihood of a Donald Trump presidency -strikingly identified by the EIU as a top-10 risk- has fallen sharply after so-called unforced errors have produced a slew of key Republican defections. But the economic and racial issues underlying his primary victory have not gone away. Upshot: U.S. political risks have risen in recent months.
4) Climate change: Climate change is a classic example of a danger that has not lacked for attention, yet falls far short when it comes to action. The 2015 Paris climate accord marks the biggest step forward to date, but doubts remain over how effectively nations will follow through and whether it is anywhere near enough. The knock on effects of climate change are themselves gray rhinos: the impact on the energy industry, the humanitarian and financial consequences of extreme weather events, food insecurity, the vulnerability of major coastal cities to rising sea levels, the extinction of species and damage to ecosystems, migration, and economic effects, and water scarcity. While investors often think of the market impact of climate change as indirect, extreme weather events can indeed sideswipe business supply chains, commodity prices, and political economy. Upshot: risks here are stable.
5) Middle East instability: An interconnected set of crises in the Middle East include ISIS, Syria's civil war, an outflow of refugees, ongoing instability in Egypt and Libya and across the region. Volatile energy prices complicate policy options for oil producers in the region, especially Saudi Arabia, and in turn for financial markets in which oil-fueled sovereign wealth funds are major investors. Increasing U.S. Russia cooperation in Syria reduces the risk of an accidental conflict between the two nations. Upshot: Middle East risks are stable, for now.
None of these gray rhino risks has gone entirely ignored. Many people and organizations are working to solve them. Yet it's impossible to say that any has been deal with adequately. And should any one of them erupt, no investor can honestly say that nobody saw it coming.
So how do you prepare for risks where "if" is less in question than "when"? It depends in part on whether your investment strategy relies more on creating long-term value, preserving capital, or riding market volatility. How to apply these strategies to each of these five gray rhinos is a whole subject unto itself.
But, speaking generally, investors should be asking themselves, now instead of when the sky actually starts falling, what opportunities each gray rhino brings. Is it a big short, or is it the opportunity to buy cheaply? What companies and industries will benefit, or at least fare least worst, in the event that any of these advances?
How quickly would a crisis unfold? Slowly, like climate change; quickly, like a liquidity shock; or a mixture, like a crisis within the EU that creates immediate market chaos and longer-term growth obstacles? Will you have a chance to get out of the way if a triggering event happens, or are you already on the sidelines waiting for the right time to buy?
The market itself is providing some answers to those questions. With global liquidity shocks high on the list of worries, we've already seen a number of big-name money managers announce that they've taken or are about to take defensive positions in cash or gold and mining stocks.
In the same vein, bond yields are hyper-low partly because of Fed policy but also because many investors are in defensive mode, the dizzy height of the U.S. stock market notwithstanding. But as cautious investors seek safety, they create new risks. Bond investors are well aware of this as they watch the Fed's every move.
You can only stay in a full-defense position for so long, and markets don't remain in holding patterns forever. And while many investors are keeping on dancing, the more step aside now instead of in a stampede, the faster markets will bounce back.
With these five gray rhinos in mind, I'll be looking carefully at Italy's referendum this fall, China's continued ability to muddle (or not), the Fed's next moves, the gyrations of commodities prices, the performance of oil prices (closely tied to how situations in the Middle East continue to unfold), emerging market and high yield debt (particularly in the oil and gas industry), the U.S. presidential election, and the price of gold. Any of these could signal a crisis or a step toward resolution and a re-alignment of the risk landscape.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.