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Gray swans: Blinded by pandemic, investors may be ignoring these risks in 2021

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Gray swans: Blinded by pandemic, investors may be ignoring these risks in 2021

When a pandemic takes over the world, it is hard to focus on much else.

But analysts and hedge fund chiefs foresee a number of potential market shocks so-called gray swans in 2021 that investors may miss.

"People, in many ways, feel like they've seen all the major risks you can see with the pandemic," said Bilal Hafeez, CEO at independent research house Macro Hive and a former chief analyst at Nomura and Deutsche Bank. "They're losing sight of all the other potential risks."

Investors and governments were blindsided by 2020's coronavirus pandemic, which has devastated companies across the globe and pushed debt to unprecedented levels as governments tried to keep their economies afloat. While many scientists and others had predicted a pandemic to occur at some point, the shutdowns that severely disrupted the economy were unforeseen, making the pandemic a possible black swan event, according to Hafeez. Gray swans are foreseeable but low-probability events that are significantly disruptive, he said.

Macro Hive's gray swan outlook includes a surge in inflation, negative Treasury yields, globalization of carbon taxes, military escalation between China and the U.S. over Taiwan, and even the discovery of intelligent life outside our solar system. Proof of aliens would cause tech and defense stocks to skyrocket and the spread between government and high-tech bonds to blow out, Macro Hive theorized.

'Priced for perfection'

The ongoing pandemic is expected to continue to be the dominant market narrative in 2021 as record highs in equities could be upset by additional lockdowns worldwide and complications with vaccine distribution.

"The market is being priced for perfection," said Paul Schatz, president of Heritage Capital. "You don't need much negativity to prick the balloon."

Schatz said his gray swan to watch is a Democratic sweep in Georgia's runoff elections in January for two Senate seats. If Democrats win these seats, the party will control the White House and Congress, granting wide latitude for corporate tax reform, stricter regulations and a dramatic jump in government spending.

"The market is not pricing it in at all, and that could have ramifications all the way to the midterms" in 2022, Schatz said.

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Mark Newton, founder of ML Newton Advisors, said that in addition to political events like January's elections in Georgia, the sheer size of the Federal Reserve's balance sheet could begin to severely weigh on growth in 2021. The balance sheet climbed above $7.24 trillion in December, a roughly 75% increase since the pandemic began.

"I see huge risks given the size of the Fed's balance sheet and trying to unwind this," Newton said. "Stocks have largely rallied in lock step with the Fed's balance sheet, all but ignoring the bad news on COVID, or economic woes."

Historic debt, combined with a slower-than-expected snapback in the economy, could create an extremely bearish event for the market, he said.

"The combination of these should be a much bigger deal than what some realize," he said.

Inflation watch

Matt Weller, global head of market research at GAIN Capital, said he is watching for a potential jump in inflation in 2021.

"A return to the double-digit inflation rates of the '70s may not be likely, but even mid-single digit inflation readings could catch many traders off guard in the next couple of years," he said.

Weller said that over a decade of large government deficits and a monetary policy that has not stoked inflation, he expects a dramatic increase in price pressures in 2021.

"By summer, many consumers will have up to 15 months of pent-up demand bursting at the seams of their wallets, and once the pandemic is finally under control, all of this demand for travel, lodging, and large discretionary items could hit the economy all at once," he said.

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John Davi, founder and chief investment officer of Astoria Portfolio Advisors, said the ongoing "skyrocketing" in M1 money indicates that a moderate surge in inflation, which he estimates to be 3% to 3.5%, is increasingly likely.

M1, which is the supply of currency in circulation, including demand deposits and checking accounts, has climbed 65% since the start of the pandemic.

A pickup in inflation is "all but certain," said Steve Lipper, senior investment strategist at Royce Investment Partners. "The investment debate will then shift to how sustained the increased inflation will be."

Still, Lipper said that while many investors were focused on the pandemic, the market may not have properly weighed the risks in the timing, efficacy and adoption of the vaccines.

"The progress has been highly encouraging, and markets have priced in a speedy and smooth distribution," Lipper said. "This complacency seems to underestimate the logistical complexity of the vaccine manufacture and deployment for which there is no historical precedent on this scale."

Hafeez said that with all attention on COVID-19, a nonpandemic event could have even more impact on the market than it may have had in years previous.

"It will be a greater surprise and should have a bigger impact on the market," he said. "We're at a very vulnerable point."