(Feb 14): A wareness of potentially high-impact but improbable developments should help investors prepare for unexpected changes in market conditions. In our base case, the global economy is poised to improve in 2020 and the outperformance gap between the US and other developed market economies is likely to shrink. After all, December 2019 brought to fruition the US-Mexico-Canada Agreement, the Phase One US-China trade deal, a US budget agreement and a clear mandate by the British electorate to follow through on Brexit. Consequently, we expect global growth to reach 3.5% barring additional geopolitical shocks. We see interest rates remaining low and inflation being contained but moving a bit higher globally.
Our base case incorporates the dynamics we see as most likely. Here, we consider the grey swans — alternative scenarios outside the scope of our base case but not beyond the realm of possibility. The market may discount their likelihood, but if any one were to happen, it has the potential to materially move markets. Our grey swan scenarios are as follows:
1. A spirit of fiscal cooperation builds in Europe
2. Chinese policy choice roils global markets
3. The Federal Reserve (Fed) lets inflation run hot
4. Technology gets de-FAANGed
5. Cryptocurrencies come of age
A spirit of fiscal cooperation builds in Europe
Although the European Central Bank (ECB) has been providing ample monetary stimulus, the region’s economy has been stuck in low levels of growth. As a result, European equities have lagged their US counterparts and continue to trade at deep discounts relative to the US. However, with large swaths of debt still reading at negative yields, it appears that monetary stimulus alone is not enough. In this context, additional fiscal stimulus could prove to be an important lever. In fact, the ECB and the Organization for Economic Co-operation and Development (OECD) have specifically called for countries with budget surpluses to invest to stimulate growth and reduce surplus to 0.5% of national GDP.
The challenge, of course, lies in the willingness of such countries to adopt these measures. The German government, for example, may not be willing to risk its political commitment to keep its federal budget in surplus.
Under our grey swan, European national governments and the ECB move toward a grand bargain, where the ECB gradually withdraws stimulus in exchange for small incremental fiscal spending from multiple countries. The Netherlands, Sweden, Ireland and over a dozen more countries have capacity for fiscal stimulus in addition to Germany under the ECB and OECD proposal. A series of small steps could aggregate to effective economic stimulus.
Political dialogue in the direction of more fiscal stimulus, less reliance on negative interest rates and true structural reforms could pique investor interest and likely spark fresh risk appetite for European equities. In this environment, being overweight to European equities (especially the financial sector) and long on the euro versus the US dollar could prove to be beneficial. We think emerging market (EM) equities also could benefit from a resurgence in European manufacturing. In our view, trimming North American equities (where valuations are full) and reducing holdings of European sovereign credits may prove to be beneficial.
Chinese policy choice roils global markets
Going into 2020, Chinese authorities are delicately balancing multiple objectives and could surprise markets in a variety of ways. China’s 2015–2016 experience in managing the yuan shows that even smaller technical policy errors made by leaders could have worldwide implications. We believe 2020 offers at least two arenas for potential miscalculation, either in China’s broader geopolitical ambitions or in the management of the domestic financial system.
For the US-Chinese trade de-escalation to hold throughout the year, China must continue to keep its trade negotiations separate from other likely sources of tension with the US. However, Beijing could make decisions that could upset this sensitive balance. Notably, the Hong Kong protests could continue to escalate, and in extreme scenarios, we could see China using force to quell the unrest. In turn, this could compel the US (and possibly Europe) to respond, which could reverse progress made on the trade front. Similarly, there is room for Chinese reactions to Taiwan’s January election results to be perceived as provocative, leading to a sudden escalation with Taiwan and its supporters.
Deleveraging the Chinese financial system requires equally delicate balancing. Beijing has allowed more credit defaults to take place (a positive trend), but the risk of a default shock persists, which could lead to broader credit retrenchments. Some evidence of this is already present. Last May, in its first bank seizure since 1998, the Chinese government guaranteed deposits but negotiated settlements for larger liabilities. To put the risk in perspective, US policymakers permitted Lehman Brothers to fail, which triggered the 2008 global financial crisis. In this context, Chinese leaders face no easy task in ensuring an ample supply of easy money to help its transition into becoming a global economic powerhouse while also maintaining its financial discipline.
Figure 2 illustrates the scale of the possible issues at stake: Beijing has aggressively managed credit growth since 2008, resulting in zero credit growth in 2018. Despite this slowdown, some market participants argue that legacy developments, fuelled by cheap credit and lax standards, already plague the system. Hence, the risk is that Chinese authorities may allow credit to build up too rapidly again, making the system vulnerable to potential price corrections. One of China’s perennial strengths has been its coherent policy apparatus, but the stakes of any policy error are also growing year by year.
At a minimum, volatility in China’s bond market or among its financial institutions could prompt investors to reassess China risks, the timing of which is interesting given the increased weight of China in equity and bond indices. Investor perceptions of China-related risks could likely fuel a broad EM sell-off.
In the event of an error in either geopolitical or financial policy, the market impact may look like a replay of the fourth quarter of 2016 — risk assets correcting across the globe and equities especially declining in the 10%–20% range. However, unlike 2016, a quick resolution would seem less plausible. Chinese government manoeuvres are not without consequences and therefore would have to be contemplated long and hard. Ergo, a quick reversal in policy, even under geopolitical duress, is unlikely and the impact on the global economy and markets could be long lasting.
In this scenario, selling risk assets geared to China — EM equities and European exporters — and buying high-quality safe assets, such as US Treasuries and the yen, may prove to be useful in our view.
The Fed lets inflation runs hot
For years, global central banks have stressed their commitment to meeting their respective inflation targets, and for years they have failed. Almost 10 years of monetary stimulus has not meaningfully affected actual inflation rates and inflationary expectations continue to sit stubbornly below target.
More recently, that commitment has been increasingly expressed in relation to a “symmetric” inflation target, implying some inflation overshoot during economic expansions to compensate for anticipated shortfalls during recessions or periods of soft growth. However, having seen central banks failing to bring inflation to 2.0%, why would investors have any more confidence in their willingness to push inflation above that level?
We could construct a scenario where US inflation exceeds target and the Fed not only lets that happen but the magnitude of the tolerated and desired overshoot takes investors by surprise.
Inflation has been firming with headline consumer price index (CPI) crossing 2.0% and the core personal consumption expenditure (PCE, the Fed’s preferred measure) moving higher. We see multiple triggers for higher US inflation this year, ranging from tight labour markets, technical factors, higher oil prices and a weaker dollar, to name the most important. The Wage Rigidity Index of the San Francisco Fed already reflects broader wage increases across the US population. As shown in Figure 3, the percentage of US workers experiencing flat wage growth has dropped dramatically from early 2018 and for the first time during this expansion has touched the 2005 highs.
In our scenario, the Fed reacts completely differently from 2017–2018, when a tightening labour market triggered worries of overheating and a series of sustained rate increases. Here, the Fed re-energizes its commitment to its symmetric 2% inflation target range and, to boost its credibility, delivers another rate cut. Under an easing bias, core PCE could near 2.5% y-o-y and headline CPI 4% by election time. Consequently, investors could finally take note of the central bank’s resolve to sustainably reignite inflation.
The investment implications triggered by this grey swan depend in part on the economic backdrop. If economic growth remains robust and corporations get some pricing flexibility, equities could hold their value. Conversely, if inflation picks up against a backdrop of slowing growth, fears of a return to the 1970s’ stagflation scenario would weigh heavily on equities. Further, in our view, Treasury Inflation-Protected Securities (TIPS) and the energy and metals/ mining space may prove to be more effective hedging tools than longer-dated bonds as the inflation scenario is deemed to be unexpected.
Technology gets de-FAANGed
Technology mega caps, including Facebook, Apple, Amazon, Netflix and Google (FAANG), are enjoying an unprecedented market run. As they continue to push the boundaries of market power, we believe the potential for major US regulatory action becomes more likely, if not in 2020, then in the relatively near future.
Three major issues are placing technology firms in regulatory crosshairs. Antitrust is clearly the first as exemplified by European regulatory action against Google and resultant large fines. Second is taxation, as countries target the technology giants for new taxes because of the disparity between their prominent role in consumers’ lives and minimal local tax obligations. Third is the issue of the ownership of digital assets and privacy, as evidenced by the Facebook- Cambridge Analytica affair, which drew regulatory attention to the acquisition, use and commercialization of personal user data. Interest from regulators has increasingly called leaders of the technology giants to Washington DC.
The likelihood of antitrust action depends in part on how the regulators describe a monopoly. Antitrust regulation which broke up the early-twentieth century monopolies (such as Standard Oil in 1911) was founded on market structure — that is, the domination of a company within the business ecosystem. The concentration of power mattered more than consumer satisfaction in the early days of antitrust regulation. In the 1980s, the description of a monopoly substantially shifted from market dominance to consumer well-being. US antitrust regulators began evaluating consumer pricing, satisfaction and overall welfare to assess monopoly power. Consumer well-being has been the lens used for antitrust action for the last 40 years.
The regulatory attitude may be reversing to address the growing dominance of the technology mega firms. Although consumers may enjoy the services, the economic power of these firms is undeniable. The US Department of Justice uses the Herfindahl-Hirschman Index to measure market concentration, using 25 as a baseline for action. Internet retailing carries a Herfindahl-Hirschman Index value of more than twice that number (53), reflecting the handful of companies selling products online and running much of the cloud computing environment. Interactive media and services (Herfindahl-Hirschman Index value of 46) may also be vulnerable to regulatory action.
We do not see risks of a new regulatory environment being priced into today’s market valuations. Historically, valuations have declined once a regulator acts based on expectations of lower profit margins and/or restricted growth following a resolution. Technology stocks tumbling would be a negative event for equities overall in the very short run as investors reset their growth expectations especially given the fact that FAANG stocks alone have accounted for more than one quarter of the 190% in cumulative return of the S&P 500 Index since 2012.
Investors may underweight FAANG stocks while revising their expected returns from these stocks. Also, in this scenario, rotating toward value stocks in the US since the FAANGs have significantly contributed to the outperformance of growth stocks; looking for companies enhancing productivity through technology; and buying developed market international equities (where valuations are already low on a relative basis) may prove to be useful strategies in our view.
Cryptocurrencies come of age
We are nearing a seminal moment in financial history with far-reaching consequences: the implementation of a state-backed digital currency. Digital currencies such as Bitcoin (whose value wildly fluctuates) have already given rise to prototype private sector stablecoins (where value is linked to sovereign currencies). Stablecoins would use blockchain technology to seamlessly and securely make payments. The private entity would redeem the stablecoin for conventional fiat currency at an established exchange rate.
The logical extension of stablecoins would be central bank digital currencies. In fact, according to the Bank for International Settlements, research into digital currency is underway at many global central banks. For example, the People’s Bank of China has indicated that it plans to launch its digital currency.
The introduction of a legitimate digital currency could be highly disruptive to the global payments system. It holds the potential to have an impact on conventional safe-haven currencies and shift global asset flows, the direction of which (positive or negative) depends on the country issuing the digital fiat currency. The US is less likely to create a digital dollar due to the enormous operational undertaking required and its cultural sensitivity to privacy. Addressing privacy issues is one current obstacle to the formation of a legitimate digital currency.
China has incentives to create a digital yuan to enhance visibility into trade and capital flows and to become a more dominant player in global finance. Admittedly, global investors may not initially embrace a digital yuan, but the practical benefits of embracing one could act in favour of such a currency. In particular, in trade finance, a digital yuan could displace the US dollar and other currencies as traders embrace the lower transaction costs and a simplified payment system. Acceptance would likely start in the Asia-Pacific region, especially among China’s regional trading partners.
The introduction and acceptance of a China-backed digital currency in the Asia-Pacific region could weaken the yen and, over time, put pressure on the US dollar and gold prices.
The bigger question is what risks the disintermediation of currency could bring to the financial sector. The ability of residents and non-residents to hold accounts with the central bank could upend existing business models for banks and other providers. And even if China’s digital yuan were to remain a regional phenomenon, the implications for other global financial institutions could be grave. Consequently, we continue to watch for the potential development of a new fiat cryptocurrency.
Closing thoughts
Our outlook is generally positive and we favour select risk assets. Some grey swans events could originate from economic surprises while others could result from new directions in government or regulatory policy. Whichever the source, markets will quickly react if investors are surprised. Awareness of these possibilities should help investors plan for an appropriate response in part so that they take precautions and in part so that they are ready to take advantage of opportunities that arise in times of swift market changes.
Lori Heinel is deputy global chief investment officer of State Street Global Advisors
