Originally published by Cuffelinks
As the first quarter 2017 comes to a close, many pressure points we saw in 2016 are still in play, and the Trump administration presents a plethora of new opportunities and risks for markets.
We have identified 10 tail risks that could roil the financial markets this year. We call them grey swans, rather than black, because they may be unlikely scenarios, but they are not implausible, exceptionally rare or unknown. Some of the grey swans we identified last year did swim by, most notably Brexit. While these scenarios are not our base case expectations, thinking about them might help inform the choice of investment strategies.
1. China loses its grip on markets and economic growth
Playing a central role, particularly in the global economy and emerging markets, China again tops our list as the leading grey swan, this time for the risk of failing to control its currency and financial markets or to manage an orderly slowdown of its economy.
Currency, financial and economic pressures continue to swirl around China. Given the shift to a more reflationary environment and greater uncertainties around Sino-US political and economic relations, we see a bigger risk to China’s ability to steer a smooth path, with potentially dire implications for other emerging markets. The People’s Bank of China (PBOC) may try to limit RMB depreciation. However, against a weaker growth backdrop and a stronger US dollar, China’s willingness to play by the current set of rules could quickly come undone if, in retaliation, the PBOC stops defending the RMB, effectively allowing it to depreciate much faster.
2. Election surprises push the European Union closer to break up
With a packed electoral calendar this year, including general, presidential and federal elections in Europe (especially France and Germany), the risk of another shock to European integration from the ballot box is real.
The question before European voters is not limited to a choice among the traditional centrist, left- or right-leaning establishment parties but between globalisation and nationalism. Look no further than the Brexit vote in the UK and the US presidential election upset to see that a platform challenging the status quo can succeed even in a large affluent democracy.
3. The Fed falls behind the curve
Realised growth or inflation that is higher than expected in 2017 could prompt the Fed to move faster to tighten financial conditions in a way that could trip up markets, slow down consumer spending and cause a further surge in the US dollar.
We believe the markets would be able to manage and perhaps even welcome a faster pace of rate normalisation attributable to more robust growth. But an inflation-heavy mix could be toxic, forcing the Fed to tighten financial conditions as consumer purchasing power is declining.
4. Oil prices uncertain again
Oil-producing nations may have reached an agreement to reduce supply, but any one country’s non-compliance with the voluntary cuts could lead to a swift collapse of solidarity and a ramping up in global oil inventories, renewing the downward pressure on crude prices.
In the past, such quotas among oil producers have been difficult to enforce. Even if the lower target holds, new sources from countries exempt from the agreement could more than make up for it. Add to that a potential revival of US shale extraction and the deregulation of some US fields under the Trump administration.
5. Emerging markets get squeezed
The protectionist rhetoric of the Trump campaign translates to new restrictions on global trade, dramatically limiting accessibility to US markets just as emerging markets (EM) are struggling with the stronger US dollar and higher US interest rates.
In the four trading days after the US election, the iShares MSCI Emerging Markets (NYSE:EEM) plunged 7% and EM debt fared no better as spreads widened sharply and EM currencies sold off. Such a negative reaction reflected the policies expected from a Trump administration: pro-growth fiscal stimulus, which would likely accelerate the pace of Fed tightening, along with a contraction in global trade flows and EM export opportunities. That details of these policies have not been forthcoming creates even more uncertainty for EM assets.
6. Productivity surges to the upside
The economy experiences an improvement in productivity growth, something lacking so far in this expansion, for no other reason than a simple reversion to the long-term trend that typically prevails over the business cycle.
Advances in technology can take years to translate into productivity gains, with current innovation in the nascent peer-to-peer economy perhaps taking longer to manifest. Capital deepening through investment spending is another means for improving output per worker, and that could pick up under the more favourable tax treatment anticipated from the Trump administration. Not all grey swans bode ill.
7. Trade wars break out
Trump’s actions to force changes in trade relationships could be seen as a foreign threat that other nations need to address aggressively, imposing their own restrictions on the imports of US goods, with China in particular having little to lose and much to gain by retaliating.
Significant protectionist trade policies employed by Trump could potentially exacerbate existing economic challenges and cause exactly the kind of volatility that China’s leadership wants to avoid. Aggressive, pro-growth policies could inflate asset bubbles or supercharge inflation, while overly restrictive capital controls could rile the markets.
8. Cyber-terrorism escalates into cyber-war
Beyond criminal operatives stealing personal data or sovereign states attempting to influence foreign elections, cyber attacks orchestrated by rogue nations remain a key risk, possibly taking the form of terrorism to weaken local infrastructure or confidence in global markets.
Recent experience suggests that many institutions are ill prepared for such an environment, lacking well-defined policies to deal with these incursions.
9. Health care becomes a policy battlefield in the US
After the hasty repealing of Obamacare before a viable replacement has been legislated, the US President and Congress are considering changes to health care while doctors, drug companies and other providers of medical equipment and services are left in the dark. In the interim, the uncertainty is likely to weigh on the health care sector and consumers.
10. New alliances form
Long-standing geopolitical and economic alliances have come under pressure in recent years, and if the US cedes ground by scrapping current agreements, this year may see new coalitions come together to replace the existing global order, with China stepping in to fill the void.
With the US pulling out of the Trans-Pacific Partnership, China is promoting its own regional trade agreement — excluding the US, of course — that some Asian nations are expected to take up.
How can you prepare for the unexpected?
These scenarios do not cover all the surprises we might see over the coming months. We suggest that investors thoroughly review whether their portfolios have adequate downside protection against tail risks and seek a partner that can help them assemble the appropriate defenses for their portfolio. Investors may consider using strategies that can help minimise volatility, while at the same time capturing return opportunities in an unpredictable market.