Unknown Unknowns

Wall Street strategists love playing games at the start of a new year. One involves predicting the 5 or 10 most impactful financial events for the coming year. An objective observer can tabulate the strategists’ predictions and sometimes detect a consensus. For example, at the beginning of 2017 the consensus outlook for the U.S. dollar was “up”. After all, the Federal Reserve had ended Quantitative Easing and had begun raising short term interest rates. Higher bond yields would strengthen the dollar, especially against the pitiful Euro which had fallen to $1.03 by the end of 2016. What actually happened in 2017? The dollar fell more than 10% versus a basket of key currencies. The Euro appreciated to $1.20. The fact is Wall Street has no crystal ball, and neither does anyone else.

The second game some strategists play involves listing events which might happen and, if they did, would have big financial impacts. This is a much more valuable exercise since it forces investors to consider a broader array of risks and opportunities. We spent some time reviewing various lists and wanted to share the following with our readers. The list is in no particular order of either significance or probability. It simply represents some events which plausibly could occur in 2018.

Possibilities in 2018

• U.S. voters push leftward at the 2018 mid-terms as disgruntled millennials opt for Sanders-style populism while many right wing populists stay home. In reaction 30 year Treasuries spike above 5%.

• Speculators flee Bitcoin which collapses below $1000.

• Higher bond yields and a shaky response by the new leadership at the Federal Reserve emboldens Congress to shackle the Fed’s independence, returning effective control to the Treasury Department (and the Administration).

• China introduces a yuan-based oil futures contract which dramatically undermines worldwide demand for U.S. dollars. This is China’s opening salvo to make the yuan the world’s reserve currency in place of the dollar.

• Iran and Saudi Arabia miscalculate each others intentions and a minor incident escalates into a new Gulf War and $150 per barrel oil.

• The relentless decline in stock market volatility, driven partly by massive investment flows into passive value-neutral products such as index funds, comes to a dramatic end. An out-of-the-blue panic strikes Wall Street a la 1987 and the S&P 500 falls 25% in just a week.

• Tencent, the Chinese tech sector goliath, surges ahead of Apple to become the world’s first corporation with a market capitalization over $1 trillion.

• The European Union taxes robots to offset the social costs from their adoption. Some EU countries funnel those revenues into “universal basic income” schemes similar to Finland’s pilot project begun in 2017. Return on capital accelerates while labor compensation stagnates as technology drives productivity gains and price deflation.

• Déjà vu 2016, the mid-term elections reinforce the old adage that “All politics is local.” And the Republicans retain control of the House and Senate, albeit with thinner majorities.

• A massive solar flare disrupts the global telecommunications network and the electrical grid. Damage amounts to $1-2 trillion and it takes months to restore basic services. The world slips into deep recession.

We end with a quote from Donald Rumsfeld which bears on all thinking about the future:

“There are known knowns, things we know that we know; and there are known unknowns, things we know that we don’t know. But there are also unknown unknowns, things we do not know we don’t know.”

It’s the unknown unknowns which make the future so interesting.

Unknown Unknowns

Wall Street strategists love playing games at the start of a new year. One involves predicting the 5 or 10 most impactful financial events for the coming year. An objective observer can tabulate the strategists’ predictions and sometimes detect a consensus. For example, at the beginning of 2017 the consensus outlook for the U.S. dollar was “up”. After all, the Federal Reserve had ended Quantitative Easing and had begun raising short term interest rates. Higher bond yields would strengthen the dollar, especially against the pitiful Euro which had fallen to $1.03 by the end of 2016. What actually happened in 2017? The dollar fell more than 10% versus a basket of key currencies. The Euro appreciated to $1.20. The fact is Wall Street has no crystal ball, and neither does anyone else.

The second game some strategists play involves listing events which might happen and, if they did, would have big financial impacts. This is a much more valuable exercise since it forces investors to consider a broader array of risks and opportunities. We spent some time reviewing various lists and wanted to share the following with our readers. The list is in no particular order of either significance or probability. It simply represents some events which plausibly could occur in 2018.

Possibilities in 2018

• U.S. voters push leftward at the 2018 mid-terms as disgruntled millennials opt for Sanders-style populism while many right wing populists stay home. In reaction 30 year Treasuries spike above 5%.

• Speculators flee Bitcoin which collapses below $1000.

• Higher bond yields and a shaky response by the new leadership at the Federal Reserve emboldens Congress to shackle the Fed’s independence, returning effective control to the Treasury Department (and the Administration).

• China introduces a yuan-based oil futures contract which dramatically undermines worldwide demand for U.S. dollars. This is China’s opening salvo to make the yuan the world’s reserve currency in place of the dollar.

• Iran and Saudi Arabia miscalculate each others intentions and a minor incident escalates into a new Gulf War and $150 per barrel oil.

• The relentless decline in stock market volatility, driven partly by massive investment flows into passive value-neutral products such as index funds, comes to a dramatic end. An out-of-the-blue panic strikes Wall Street a la 1987 and the S&P 500 falls 25% in just a week.

• Tencent, the Chinese tech sector goliath, surges ahead of Apple to become the world’s first corporation with a market capitalization over $1 trillion.

• The European Union taxes robots to offset the social costs from their adoption. Some EU countries funnel those revenues into “universal basic income” schemes similar to Finland’s pilot project begun in 2017. Return on capital accelerates while labor compensation stagnates as technology drives productivity gains and price deflation.

• Déjà vu 2016, the mid-term elections reinforce the old adage that “All politics is local.” And the Republicans retain control of the House and Senate, albeit with thinner majorities.

• A massive solar flare disrupts the global telecommunications network and the electrical grid. Damage amounts to $1-2 trillion and it takes months to restore basic services. The world slips into deep recession.

We end with a quote from Donald Rumsfeld which bears on all thinking about the future:

“There are known knowns, things we know that we know; and there are known unknowns, things we know that we don’t know. But there are also unknown unknowns, things we do not know we don’t know.”

It’s the unknown unknowns which make the future so interesting.