Looming Black Swans Could Hurt 2017 Stock Market Forecast

The current social and political conditions could lead the world economy to disaster. The financial markets have never been more susceptible to disruptive events. Yet the stock market forecast for 2017 has not taken the biggest risk into account.

This is nobodys fault, because no stock market forecast can possibly foresee the biggest risk. Most everybody can make a correct market prediction, even without knowing a thing about a stock, but nobody can predict a black swan event. The very nature of a black swan is to elude everyone, including Nostradamus himself.

The black swan theory, or the theory of black swan events, is a metaphor. Its a term to describe the concept that a heavy-impact event comes as a surprise to the observer. Once that happened, the event is rationalized in retrospect. The theory was developed by Nassim Nicholas Taleb to explain the weaknesses of such things as a stock market outlook or a stock market forecast.

High-impact events such as a black swan are not just rare and difficult, if not impossible, to predict. They play a disproportionate role compared to normal expectations in the context of history, science, technology and finance. A black swan event can only be recognized after the fact.

Heres what this means for where the stock market is headed. Geopolitics is key. Thus, it is important to increase the awareness of firms operating in international markets today, even more than in the past.

In 2017, the Venezuelan default and the growing tensions between the U.S. and Iran could be traumatic, leading to a potential collapse of oil prices and another war in the Middle East. Raw materials could be subject to extreme fluctuations in 2017.

Tensions between the U.S. and Iran and the risk of a default in Venezuela may push up oil prices, possibly to unsustainable levels for emerging economies. Further, the situation in Ukraine and Russia is even more difficult to predict now.

During the Barack Obama presidential administration, it was clear that Washington sided with Ukraine, but President Donald Trump wants to improve ties to Moscow. That could encourage the latter to turn the situation back in its favor. Such tensions could boost the prices of industrial metals, given the strong role both countries have in mining.

Barclays Bank PLC has come up with a chart outlining some of the potential black swan events, as summarized below. Note, the threat type is what is affected by the potential black swan event. So, in the case of oil, its price would go up if the U.S. and Iran clash. The black swan in that case would be the spark that leads to the clash.

There is no way to assess the probability of such periodic rare events using scientific methods. By definition, a black swan event has a very low probability of occurring. Iteludes mathematics and statistics. Thus, an airplane crashing into the World Trade Center on September 1, 2001 was a black swan event.

Arguably, the discovery of how to make fire was a black swan, as was the big bang of the Big Bang Theory. In the purely financial context, black swans are rare. The 2007/2008 financial crisis was not a black swan, for example. It was all too predictable to those who had access to the information, or those willing to consider it.

Yet, most investors who work 40 hours a week have little time to check every detail that could affect their portfolios and retirement savings. To themthat is, to most peoplethe 2008 subprime crash certainly had the impact of a black swan. By stretching or altering the definition of black swan, we can analyze them to see where is the stock market headed.

A true black swan will make mincemeat of any stock market prediction. But the more liberally defined black swan event, described above as a heavy-impact event, can be very useful.

It turns out that 2017 will be a year dense with such heavy-impact events.

The first of these foreseeable black swans concerns the Trans-Pacific Partnership (TPP). It took years to negotiate and achieve, but it also took just one signature from Donald Trump to terminate the U.S.s participation. That was no black swan, however. Trump said he would scrap the deal during the election campaign.

The scrapping of the TPP will have consequences; it could spark a cascading chain of high-impact events. Given the global impact of these events, they will affect the stock markets. They can also produce a black swan, but we can only examine and predict events as the conclusion of ongoing processes.

To be clear, the end of the TPP is a hugedeal. Major investment banks like Goldman SachsGroup Inc (NYSE:GS)and the World Economic Forum (WEF)which just met at Davos a few weeks agofeared this. The reason for their worry is that, at the stroke of a pen, Trump has inaugurated a new era of protectionism.

Protectionism will be a major threat to the world economy in 2017. The risk that Trump would ditch the TPP agreement was well known months before the U.S. election. The TPP is such a threat because it compounds the effects of the Brexit which, while not a black swan per se, are unclear. Its not even clear whether the U.K. will go along with it.

The TPP and Brexit are mere reflections of the protectionist trend that should concern all investors. They reflect the fact that populist movements are strengthening. Yet, all the while, the migration crisis continues and the risk that many fear is another series of terrorist attacks. Again, these are not black swans in themselves, but they provide the basis for one.

Meanwhile in Asia, there is another known risk that could produce predictable and unpredictablehence black swanrepercussions. Chinas economy could implode because of unsustainable levels of debt. The Chinese debt bomb could slow Chinas economy and become an obstacle to global economic growth.

The geopolitical realm has within it the seeds of many risks for humanity in 2017. These include terrorist attacks and the inter-state conflicts resulting from the rising problems of regional and global ungovernability. International institutions will need to negotiate and work together to solve geopolitical and economic problems in 2017.

The geopolitical litany of risks with black swan potential is unprecedented in 2017. The closest period like this that comes to mind is World War 1. The worlds superpowers were experiencing a protectionist-fueled suspicion of each other. Meanwhile, rapidly changing technology on one hand and rapidly advancing revolutionary social movements on the other mixed to create economic and political TNT.

The black swan component that nobody could have predicted was a young man in Serbia called Gavrilo Princip. He murdered the archduke Franz Ferdinand, sending the spark that set off the TNT. That event on June 28, 1914 was unpredictable, and its timing and context produced World War 1, the risks of which had become rather obvious in the first decade of the 20th century.

That odd sensation that many investors get every day now reflects a similar scenario today. The next Black Swan event might be that one that sparks World War 3.

In 2016, Russia, South Africa and many other countries have withdrawn from the International Criminal Court (ICC). Meanwhile, China has refused to accept the ICCs verdict on the territories in the South China Sea.

Trump has threatened to terminate the contract with Iran. Even if an agreement is reached over Syria and ISIS is defeated, the sentiment that produced the latter movement and the tensions in Syria remains. It will not simply vaporize.

ISIS might be gone, but its ideology has the advantage that anyone can adopt it. The mixture of dissent and mistrust that is brewing among the world powers has already paralyzed the United Nations (UN).

Meanwhile, the European Union (EU), which was formed after World War 2to act as a guarantee that no such war could break out again, has began to disintegrate.

Among the factors contributing to geopolitical tension is a deficit of trust. Countries accuse each other of interfering in their internal affairs. Look no further than the allegations from the U.S. Democratic Party that Russia interfered in the November presidential election to ensure that Trump would win.

In effect, nobody has proven that Russia was behind the WikiLeaks release of the John Podesta e-mails. But the media, many Americans, and others around the world have blamed Russia, fueling the mistrust among nuclear superpowers. In such an atmosphere, any number of events could turn out to be black swans for the next major international conflict.

Black swan events would only reveal themselves in retrospect after analysis of the one cause that sparked it. That is, if any analysts live to study it. Such black swans may result from the socio-economic risks like mass migration, the critical increase in inequality, and the polarization of society along ethnic, religious and cultural factors that could seriously complicate the situation in 2017.

The results of the U.K. Brexit referendum and the U.S. presidential election have shown that such factors seriously affect the situations in different countries. Then there is an escalating arms race involving the United States, Russia and, now China.

The risk of a black swan in the arms race context could certainly play on the explosive geopolitical context. The current arms race involves military robotics and artificial intelligence (AI). Drones are merely an early generation of the military-technological evolution.

Robot soldiers are no longer the figment of a science-fiction writers imagination. In 2017, we are already bombarded by technological risks. Consider cyberattacks alone. These can take the form of fraud and data theft, defects in software that can cause a failure in the energy sector (nuclear reactor meltdown), transport, communications, etc.

Moreover, the rapid development of new technologies and robotics will make human labor increasingly obsolete. The fact that this coincides with an ever-growing population presents huge risks for unemployment and social instability. Therefore, it is the perfect storm for massive social unrest.

On top of that are otherrisks, such as natural disasters. These are virtually impossible to avoid. For all other risks, we can study processes and developments, trying to make sense of them. At best, we can predict what systems could be affected by a black swan event, although nobody knows what form this will take.

The very unpredictability of black swans is the stuff of intense philosophical debate. The unexpected is what moves the world forward (or backward). The advent of the Internet was a black swan. Designed as a military communications and security tool, nobody could have foreseen the role it has come to play in modern life and business.

Life rarely works exactly as you plan it. We must learn to live with uncertainties and deal with the unexpected. Black swans are reminders that, despite the combination of technological wonders, forecasting tools, and organizational devices, we are not able to defeat nature and chaos.

Therefore, its impossible to have an accurate stock market forecast based on black swans. But we can still analyze and pay attention to the kinds of risks from where black swans might arise, or where they may have an impact.

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Financial Black Swans Could Rock 2017 Stock Market Forecast - Lombardi Letter