3 Potential ‘Black Swans’ to Watch For: 3EDGE

The markets today are ‘even more susceptible’ to black swan events than before, according to 3EDGE’s president Stephen Cucchiaro

“There are no shortage of black swan type events lurking in the wilderness,” according to Stephen Cucchiaro, 3EDGE Asset Management’s president and chief investment officer.

Cucchiaro founded 3EDGE, a Boston-based global, multi-asset investment management firm, in January of 2016.

While the firm is new, Cucchiaro has a pretty extensive history in investment management. He founded, and served as chief investment officer, of Windward Investment Management until June of 2014. Windward, now called Windhaven Investment Management, was acquired by Charles Schwab in 2010.

3EDGE uses primarily exchange-traded funds for its two strategies, the 3EDGE Total Return Strategy and the 3EDGE Conservative Strategy. The firm recently reached more the $300 million dollar mark in assets under management and predicts it will meet the $500 million dollar mark by the end of this year.

During a press briefing in New York, Cucchiaro explained three “black swan” scenarios that could come into play in the fourth quarter of 2016.

“We think that the time like we’re in today, the market’s even more susceptible to these [black swan type] events than before because we really believe we’re in the lower return world moving forward and a lot of that is caused by central banks,” he said.

1. Low interest rates and flattened yield curves

“We’ve never seen interest rates this low in the history of mankind,” Cucchiaro said.

As the central banks pulled all the interest rates low, that created “very flat” yield curves, according to Cucchiaro.

“As you’re trying to grow an economy, the last thing you want to do is have a flattened yield curve,” he said. “An inverted yield curve almost always leads to a recession. A flattened yield curve makes it really difficult to grow an economy and create liquidity.”

In September, the Bank of Japan announced it would keep the long-term 10-year rate at 0% and keep the short-term rates at negative in an attempt to start to create a yield curve.

“In a way, that’s like taking a bb gun to where they need a bazooka, but at least we’re hoping it starts a conversation that yield curves are important,” Cucchiaro said.

(Related: 4 Events That Could Disrupt Global Markets in Q4: Russell Investments)

Meanwhile, Europe has been ineffective at growing the economy, “which is what they need to do,” Cucchiara said.

“They’ve been ineffective at growing inflation rates,” he added. “They keep lowering rates into more and more negative territory, but they’re banking systems are having a tough time making a profit. And a lot of that’s because they have very flat [yield curves].”

In the U.S., there’s a lot of speculation about a rate hike in December. Cucchiaro hopes the Federal Research doesn’t hike short term rates, while long-term rates stay low, which he says would flatten the yield curve “even more.”

“It would be beneficial for the economy and markets if they allow the long-term rates to tick up to a normalized level and go easy on the short rates and allow that yield curve to steepen,” Cucchiaro said.

Depending on what the central banks do – particularly the Fed – in the fourth quarter could surprise investors and cause some disruption in the bond market.

2. Inflation

Inflation is another potential surprise, or black swan, that Cucchiaro is watching.

“Investment markets for a long time now have been forecasted … literally no meaningful tick up in inflation for the next 10, 20, 30 years,” he said. So, inflation insurance, meaning buying treasury inflation protected securities, is very, very cheap.

However, according to Cucchiaro, there are some early signs inflation is starting to tick up.

The Consumer Price index (CPI) is up 1.1% year-over-year as of the end of August. However, Cucchiaro noted that the Core CPI, which excludes energy and food prices, is up 2.3% year-over-year as of the end of August.

“With energy prices stabilizing and with wage growth stabilizing and starting to tick up, I do think we can see a narrowing between CPI and the Core CPI and actually getting back over 2%,” Cucchiaro said. “We think that it will be really hard to justify a U.S. Treasury bond yield at under 2% when core inflation soon [and] headline inflation will be up over 2%.”

3. A long-standing trading range of equities

The equity markets have been in a narrow trading range of equities for a “very extended period” – which could be another “black swan” event if that changes, according to Cucchiaro.

“Whenever a market stays within a trading range for a very long time, when it finally breaks out of that trading range, there’s often an exaggerated move in behavior,” Cucchiaro explained. “People see that there’s a new change in behavior and people pile on to that break out.”

What could cause a break in the current trading range?

According to Cucchiaro, “if we had an event that forced the equity market to break out below this long-standing trading range, there could be this behavioral response. People breaking out, selling, moving … that could drive the next serious correction.”

One event that Cucchiaro has been watching is what’s happening in the European Union and Brexit. “Now Brexit came and went, it didn’t cause the kind of short-term calamity a lot of people feared,” Cucchiaro said.

However, Italy is scheduled to hold a referendum on constitutional reform on Dec. 4, which has some worried of an “Italexit.”

“We do think that there are a number of black swans – in addition to that there’s a lot of geopolitical tensions going on in the world that could possibly be black swans as well,” Cucchiaro said.

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