Usually, black swans in financial markets are meant to refer to big, bad panics characterized by massive waves of selling. Asset prices formerly thought to be uncorrelated fall en masse, and liquidity evaporates. In other words, something like 2008.
"These are extreme events characterized by massive outflows from all risky assets, creating a systemic financial crisis," said Roger Aliaga-Díaz, a senior economist with Vanguard's investment strategy group. "All risk assets tend to perform poorly, and there's a general flight to quality by investors."
With a bona fide black swan in our recent past, it's a fair question to ask whether others could be lurking in the weeds. Is the increase in volatility this year a prelude to a bigger fall in the markets? What might trigger a more severe loss of confidence, and how — if at all — can investors protect themselves from such a scenario?
Answers are hard to come by. Black swans, by definition, are hard to predict and typically cause a major shift in the prevailing perceptions of investors. Neither market analysts nor media outlets are likely to be reliable guides for when and where potential black swans might emerge again.
"Black swan events are things you don't imagine as you're going into them, but they seem logical in hindsight," said Wesley Phoa, a fixed-income portfolio manager at Capital Group, manager of American Funds. "Our job is to try to imagine what those things might be and to come up with game plans to deal with them."
A shortlist of potential events that Phoa thinks could cause major volatility in financial markets include the following:
Any and all of these events could seriously affect investor sentiment across global markets and reduce their appetite for risk. Other political or economic developments could wreak similar havoc.
Whether they provoke a wholesale repricing of risk by the markets, however, depends as much on the environment as the event itself. "You have to think about not just what can go wrong but what kind of contagion it might cause across markets," said Phoa.
Leverage is almost always a key factor exacerbating panic in financial markets. As asset prices fall, leverage magnifies the losses and force institutions and investors to sell other assets in their portfolios.
The cascading effect can drive down the prices of even high-quality assets that would normally be considered safe havens for investors.
The situation gets much worse when the leverage is poorly disclosed or hidden. The growth of the "shadow banking" system in the early 2000s is arguably the biggest reason for the failure of the banking industry in the financial crisis.
Trillions of dollars in loans were extended by banks in "off-balance sheet" transactions that were never disclosed in their public filings.
The financial system in developed markets today is far more stable than it was prior to the crisis. The Dodd Frank Act may have deserved the criticism about regulatory overreach, but it has helped put the banking system on more solid footing.
The reserves of banks in the U.S. and euro zone are significantly higher, and leverage is significantly lower. "We've paid for it in terms of economic growth and flexibility, but systemic risk in the financial system has gone down a lot from pre-crisis levels," said Phoa.
It hasn't disappeared, however.
The two areas most commonly cited as potential breeding grounds for the next black swan event are China and the uncertain outcomes of the ultraloose monetary policies in developed world markets.
The slowdown of the Chinese economy has been a source of concern for global investors for years. The emerging markets, with China as the linchpin, account for more than 50 percent of global domestic product now, and if the Chinese economy is slowing more dramatically than anticipated, the global economy will suffer.
Of late, however, the problem isn't just that the economy is slowing — and likely at a much faster pace than official stats suggest — but that Chinese policymakers are stumbling in their management of it.
The erratic behavior of government policymakers still learning to live with the often-erratic behavior of free markets has shaken the confidence of investors in China's commitment to reform its markets and economy.
The government remains obsessed with setting and meeting growth targets and maintaining controlled currency-exchange levels. While it still has enormous foreign-exchange reserves, the Chinese government will be hard-pressed if capital outflows — $500 billion last year — accelerate further.
"Chinese policymakers are juggling a lot of balls now," said Vanguard's Aliaga-Díaz. "The quality of their policy and the communication of it to the markets is not the same as here."
The contagion that accompanies a black swan event is often a result of a major misread of a widely accepted belief. The more we believe in the illusion of control, the more vulnerable we are to losing it in catastrophic fashion. If the central planners in China continue to try and control their economy and resist market reforms, things could get very messy.
The issue of control also arises when it comes to the monetary policies of developed markets. In December the U.S. Federal Reserve ended its zero rate policy of the last seven years, but the real rate of return for risk-free assets has been negative since the financial crisis.
"When prices come down and spreads widen out, it fosters an environment for investors to do better, not worse."
-Jay Leopold, head of U.S. investment risk at Columbia Threadneedle Investments
While few economists would argue with the Fed's ultra-accommodative policy when the financial system was on the verge of collapse, the return to a more "normal" monetary policy is now fraught with uncertainty.
There is also the Fed's multitrillion-dollar securities portfolio amassed in the QE programs that sits like a giant blob astride the market. What happens if and when the Fed decides to stop reinvesting the funds from maturing bonds back into the market?
"We have no data points to suggest what could happen," said Jay Leopold, head of U.S. investment risk at Columbia Threadneedle Investments. "This has been unprecedented monetary policy."
He added, "It's a classic example of an environment that's difficult to model. We're in uncharted territory."
Black swans are scary things, but if avoiding them were investors' sole concern, they would never put their money in the markets. "I'm a bond guy; my job is to worry. But if you spend too much time dwelling on the negatives, you become overly conservative," said Phoa at Capital Group.
The uptick in volatility over the past six months is a good reminder that investing involves risks, and it may be a form of inoculation against a more acute loss of confidence in financial markets.
"The volatility today is creating opportunities for more reasonable rates of return on risk," said Leopold at Columbia Threadneedle Investments.
Like all good financial advisors, Leopold suggests investors diversify their risks and stick to their investment process.
"When prices come down and spreads widen out, it fosters an environment for investors to do better, not worse," he said.
This article is originally published on www.cnbc.com