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In search of the 'unknown unknowns'

·Editor focused on markets and the economy
·4 min read
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This article first appeared in the Morning Brief. Get the Morning Brief sent directly to your inbox every Monday to Friday by 6:30 a.m. ET. Subscribe

Tuesday, December 7, 2021

Never let a bull market lull you into complacency

“There are known knowns — there are things we know we know. We also know there are known unknowns — that is to say, we know there are some things we do not know. But there are also unknown unknowns, the ones we don’t know we don’t know.”

~ Donald Rumsfeld

The sage if not convoluted soundbite, uttered in 2002 by the recently deceased former U.S. Defense Secretary on the cusp of the Iraq War, occurred to me as I sifted through the detritus of my email inbox on Monday morning — filled as it was with reminders of a volatile week.

For those just catching up, the Omicron variant is menacing investors (though you couldn’t tell, judging by Monday’s price action), a suddenly inflation-centric Federal Reserve is spooking cryptocurrencies ... but the U.S. economy is chugging along just fine, thank you very much.

“Omicron has put quite the wrinkle in the recent bull market, but stocks are still up more than 20% for the year, so it is good to put things in perspective,” noted Ryan Detrick, chief market strategist at LPL Financial.

“After more than a 110% rally from the March 2020 lows, perhaps investors needed a reminder that stocks can’t go up forever and that while volatility might be frustrating, it is perfectly normal,” he added.

Taking the time to digest an event-filled few days, two critical data points gave the Morning Brief an opportunity to invoke Rumsfeld’s memorable line about trying to war game for the unexpected.

After a brief slowdown in the third quarter, Wall Street economists are getting bullish about the current quarter and beyond — provided inflation and the Fed’s plans for monetary policy don’t completely derail investors’ best laid plans.

IHS Markit’s Joel Prakken and Chris Varvares expect that Q4 growth will spike above 7%, “driven by a rebound in vehicle production and unexpected strength in exports and inventory investment. The transition from COVID pandemic to endemic, gradual resolution of supply disruptions and labor shortages, and still accommodative financial conditions will support continued expansion into 2022 even as pandemic-era fiscal support wanes.”

And over at JPMorgan Chase, investment models “continue to see very little risk of recession beginning within the next 12 months given the generally rapid pace of improvement in the economy.”

The banking giant added that through November, “our model placed essentially zero probability on a recession occurring in the next 12 months [emphasis mine]. In the untruncated version of the model that we track as a tool for interpreting the data flow, there was very little deterioration or improvement in November, except for occasional ups and downs.”

Currently, few (if any) investors foresee a risk of recession. That might not be as good as it sounds.
Currently, few (if any) investors foresee a risk of recession. That might not be as good as it sounds.

Even though JPMorgan’s data has reflected marginal risk of a downturn this month, demand-driven inflation still remains the base case, which is also driving expectations of a more hawkish Fed. And given a messy, unpredictable world with proliferating risks, that sort of unvarnished bullishness might be a problem.

So, you might ask, where does Don Rumsfeld fit into this scenario?

In essence, the defense secretary’s infamous quote is the political equivalent of what financial market watchers refer to as hunting black swans (and no, this isn’t a callback to the 2010 Natalie Portman movie with the same name).

In this instance, it refers to the highly improbable event that virtually no one sees coming — with devastating consequences, i.e. the shockwaves from Lehman Brothers’ bankruptcy that ignited the 2008 financial crisis.

At this stage in 2021, COVID-19 is a “known known.” The surfacing of variants (Omicron, Delta, etc.) are “known unknowns,” or things we know about, but aren’t entirely sure how they’ll progress.

However, the “unknown unknown” is the thing nobody expects that triggers a crisis. A new financial/economic calamity sparked by excess liquidity/stimulus? A terror attack? An armed conflict with a foreign power (Iran, China, Russia — perhaps all three)?

All of the above?

Citing Russia and Iran as "tailwinds" giving a boost to safe-haven bonds, Blue Line Futures Bill Baruch told Yahoo Finance on Monday that "there’s a lot to pay attention to in the geopolitical landscape."

No kidding. And if there's any lesson the COVID-19 era has imparted upon us, it’s that you should always brace for the “unknown unknowns” — even if a bull market lulls you into a false sense of security.

By Javier E. David, editor at Yahoo Finance. Follow him at @Teflongeek

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