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Investor 500: Black swan hunting

We asked a handful of experts to suggest some potential high-impact events on the horizon that prudent investors should bear in mind.

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The deflation shock: New series 2001 $1 bill notes pass through a printing press. Photo: Alex Wong/Getty Images

In 2007’s The Black Swan, Nassim Nicholas Taleb used the term as shorthand for an unpredictable, high-impact event, citing examples like the invention of the Internet, the outbreak of the First World War and the 2001 terrorist strikes on America. We asked a handful of experts, for whom predicting the unpredictable pays the bills, to suggest some potential black swans on the horizon. While none are probable, they represent the kind of risks (and opportunities) that prudent investors should bear in mind before betting it all on a particular stock, sector, or even asset class.

Stagflation’s return
According to BMO Capital Markets global-currency and public-policystrategist Andrew Busch, the health-care reform legislation just passed in the U.S. sets up the potential for a 1970s-style cost push scenario, “where a government program is being phased in with higher taxes and is ultimately inflationary, along with a lot of liquidity in the system occurring while the economy is growing again and while the Fed is going to be struggling to reduce its balance sheet and raise interest rates.” What’s more, some components of the U.S. health-care reform have a tax on investment income that’s not indexed for inflation, which for Busch recalls the absence of inflation indexing on tax brackets in the ’70s. If stagflation returns in 2012 or 2013, he sees bondholders losing, stocks going sideways, gold and commodities booming, and conceivably, real estate returning as an asset class.

A typhoon hits Shanghai
Hurricane Katrina showed the level of destruction a storm can wreak on a developed city, and while a hit on New York isn’t impossible, another global financial centre is extremely vulnerable. “Shanghai is like New Orleans,” says Cleo Paskal, author of Global Warring: How Environmental, Economic and Political Crises Will Redraw the World Map. “It’s very low-lying, it’s in an active delta, it’s in a typhoon zone. For the last few years they’ve been evacuating literally hundreds of thousands of people from that coastline in anticipation of typhoon hits.” Paskal says a direct typhoon hit on Shanghai could have severe repercussions, economically and globally. “If the hit is severe enough, China may have to sell off T-bills in order to fund domestic reconstruction, and pull out of strategic foreign investments for the same reason.” In that scenario, she expects China to dump its holdings in secondary markets like Europe.

The deflation shock
“Most of the people who’re optimistic think we’ve had a bottom and everything is turning the corner,” says Robert Prechter, editor of ElliottWave.com and author of Conquer the Crash. “And the bears for the most part think we’re going to have hyperinflation, so you should buy commodities, gold and silver. But I think the opposite is true: that the most desired financial asset for the next six years at least is going to be cash.” Prechter sees the positive mood that’s reflated the system turning sour, and thinks that large amounts of debt will lead to a contraction of the credit supply.

A resurgent Japan
Busch can imagine disagreement among Asia-Pacific countries over sourcing energy that could lead to trade disruptions, resulting in a more assertive Japan. “I would expect increasing Japanese intolerance of U.S. hegemony in the region, and stronger pushback for Japanese interests instead of just following along with the U.S.” He also expects more discussion about American military bases in Japan, and anticipates that Japan won’t hesitate to use its military strength to project power, not least navally.

A natural gas cartel
Vincent Lauerman, president of Calgary-based Geopolitics Central, can imagine the ascent of an Organization for Gas Exporting Countries. Historically moving in tandem, the price of oil has shot up again, post-recession, while gas has been hit with a “double whammy” of a recession-fuelled drop in demand and a surplus of new production from shale coming online, in Canada and the U.S. particularly. Countries like Qatar, which built up capacity to serve the U.S. market, now find themselves with excess. With substantially more capacity coming online within the next five years, Lauerman can imagine a “global energy glut.” A cartel would be the obvious solution to managing supply and keeping prices up. Says Lauerman, “Once you get a whiff of a gas cartel coming online, barrel on in, my friend.”

A war against the oilsands
Though he doesn’t see it happening at the federal level, Lauerman sees potential peril for the oilsands if California’s Low-Carbon Fuel Standardcatches on widely at the state level. “As of now, a number of primarily northeastern states have said they’re going to follow suit, but we don’t export much oil there, and we don’t plan to. But if it spreads to the Midwestern states, our current core market, that could be a huge issue.” The anti-dirty-oil lobby is increasingly powerful and well-funded, Lauerman says, and with tailings pond wildlife deaths catalyzing public opinion, there is a low-probability scenario in which oilsands development gets curtailed.

The big thirst
“Right now, in most economic equations water is valued at zero,” says Paskal. But as it becomes an increasingly critical resource for agriculture and energy production (as much as 40% of fresh groundwater in the United States and Europe passes through an energy plant at some point), that may no longer be feasible. “A lot of economic calculations about what is viable will need to be reassessed. The water supply isn’t so much a water issue as it is an energy issue.” We could see one vulnerable province start bulk water sales, opening the floodgates under NAFTA. But the Holy Grail of water science, Paskal says, is a cheap desalination technology: “Whoever comes up with that is going to be a very rich person.”

The collapse of OPEC
One of the reasons behind the last Iraq War, says Lauerman, was the establishment of an American foothold in the Middle East, with an eye to the neo-con dream of “breaking the back of OPEC.” Now that Iraq has stabilized somewhat, its government has awarded contracts to foreign companies to boost its oil production from 2.5 million to 12 million barrels per day. “Obviously, the market wouldn’t be able to handle that.” Lauerman thinks Iraq is trying to get a quota higher than Iran’s and closer to Saudi Arabia’s – but with the country’s vast production potential, it could, if motivated, break up the cartel’s hold on oil prices.

A new Cold War
Lauerman can conceive of the world once again breaking into two blocs: “a democratic capitalist bloc led by the U.S. and an authoritarian capitalist bloc led by China.” Relations between the two powers have been bumpy lately. “Obama’s doing everything possible to keep the relationship on a relatively even keel,” he says, “but the U.S. Congress and the American people are pretty angry at this point. If you have a stagnant economy, you’re running a deficit, and you look across the water at this country that’s got an undervalued currency and a booming economy, it’s easy for that to translate into the sort of legislation that would ultimately lead to a trade war.” That could lead to tariffs on Chinese goods, and to China cozying up further with authoritarian regimes.

D-Day for the big U.S. banks
“If you begin to look at what ‘too big to fail’ is all about,” says Busch, “the unstated backing of them by the U.S. government gives them the benefit of being able to borrow at reduced cost in comparison to their competitors. That’s something that upsets many in Washington.” If the U.S. government were to break up the country’s biggest banks, Busch says, “the entire banking sector would be up for grabs.” Smaller banks would benefit from the reduced competitiveness of the larger banks, as would foreign banks, like ours.