At times, investors tend to underestimate risks that seem unlikely to happen. After all, the investment landscape is full of uncertainties. There are already many likely and impactful risks for investors to worry about. But potentially high impact risks that have a low probability of occurring are important to consider as well while building and managing portfolios.
Take for example, the inflationary episode of late 2021 and early 2022. Decades of moderate inflation had conditioned markets to believe that the odds of inflation staying high for a sustained period was low. In early 2021, stickier inflation was a low probability event. So, when inflation started rising in mid-2021, investors expected it to be temporary. Even central banks thought there was very little chance that inflation would spiral out of control. But by mid-2022, when inflation remained high, it hurt consumers and markets as central banks were forced to tighten financial conditions. Overlooking the possibility of stickier inflation came back to haunt various stakeholders.
Therefore, considering low probability but potentially high impact risks is helpful to construct multi-asset portfolios. Forecasting their potential impact is one way to validate a portfolio’s robustness. It gives an idea of how these financial assets may under or over perform if an unlikely risk plays out. It also helps to shed light on which assets can withstand the effects of those events and if any portfolio changes could be appropriate.
For 2023, here are some of the low probability but high impact risks that we are thinking about:
1) Inflation may resist falling below 4%-5% in the U.S. and Canada as demand for labor keeps wages high. The reopening of China’s economy could drive up commodity prices and the Russia-Ukraine conflict could further disrupt the supply of energy and grains. These factors may force central banks to raise interest rates significantly higher for the second straight year in 2023. Higher borrowing costs in turn could weigh on markets.
2) As the European Central Bank raises interest rates to fight inflation, it might adversely affect weaker eurozone economies such as Italy, Portugal and Greece. Resulting political tensions may trigger eurozone breakup risks. This could threaten the region’s common currency (the euro) and assets valued in euros.
3) As nominal economic growth slows or reverses from last year’s torrid pace, an unexpected default or a missed loan payment by a sizeable investment grade or high yield debt issuer could panic credit markets. This could reduce risk appetite for lending to borrowers. As the flow of credit gets affected, other risk assets may also re-price lower accordingly.
4) Demand for housing in key markets could weaken significantly more than is currently expected if financial conditions remain tighter for longer. If central banks do not reduce interest rates in the future as much or as quickly as markets currently anticipate, this may lead to housing supply exceeding demand beyond previous analyst forecasts. The domino effects of prices declining more than mildly could in turn hit consumption and risk appetite as consumers feel less wealthy. Further, banks may get more reluctant to lend against the falling value of homes. These factors could accelerate an economic downturn.
The risks listed above may seem remote. And they may not dominate the minds of risk management teams as they are perceived to have a low probability. But understanding their potential impacts helps us deal with unobvious risks. We believe factoring these unlikely risks helps us build resilient multi-asset portfolios.