Remember 2008’s Wicked Black Swans? This Year, Look Out for Gray Swans
Art by Chris Buzelli
Institutional investors are planning for volatility to be a regular feature of markets in 2019, but it may not be all bad. A recent survey of institutional investors from Natixis Investment Managers suggests that allocators are maintaining their return expectations despite the potential for slower growth this year.
As a result, investors and managers are thinking through what slow growth could look like as well as some potential shocks. Lori Heinel, deputy global chief investment officer at State Street Global Advisors, has put together a list of gray swans that could impact markets this year. Unlike black swans, a term used to describe catastrophic drawdowns, a gray swan could lead to a sell-off but isn’t likely to send markets into a depression—and may bring a nice opportunity.
“We don’t think any of these scenarios are very likely, but we have seen some indications in recent weeks that one or a couple of them could happen,” Heinel tells CIO. “Concerns around the trade war are deepening, corporate debt levels are rising, and we are likely to see an increase in oil prices this year. We have been encouraging investors to weatherproof their portfolios before a crisis occurs.”
Heinel’s Six Big Gray Swans
- China lets its currency fall as the trade dispute escalates and reserves wane
- Oil spikes to $90 a barrel
- A major institutional default triggers a flight from over-levered sectors
- Europe surprises to the upside
- The US cycle extends much further than consensus expects
- Japanese inflation breaks out and Bank of Japan (BOJ) is forced to hike
“We don’t think any of these scenarios are highly likely, but we have seen some indications in recent weeks that one or a couple of them could happen,” Heinel says. “Concerns around the trade war are deepening, corporate debt levels are rising and we are likely to see an increase in oil prices this year. We have been encouraging investors to weatherproof their portfolios before a crisis occurs.”
China
China could be impactful for many of the scenarios on this list. China has kept its currency pegged to the dollar as part of a broader effort to support local growth and international commerce. But if trade talks stall, the People’s Bank of China could dip into its reserves in order to let the yuan fall.
A resulting stronger dollar could trigger a sell-off in emerging market equities and make tariffs a bigger burden for US consumers.
Oil
China could also impact oil prices this year. If Chinese demand for oil goes up even slightly, global growth surprises to the upside, or issues in Latin America worsen, there is potential for oil prices to increase. Heinel’s call of $90 per barrel represents the high end of a potential trading range, but she says its likely oil will go up this year either way.
Christopher Zook, chief investment officer of multi-family office CAZ Investments, agrees. His base case is a trading range of $40/barrel at the low end and $70/barrel at the high end. “What we’re seeing so far is that OPEC is backing off production, but at $50, a significant amount of US production is economic. If prices rise, you’re going to see more producers come into the market. Opportunities in energy is a big theme for us this year.”
US Up Cycle Extended
As investors try to handicap where markets might shake out this year, three issues—inflation, leverage and rates come up again and again. Heinel also reflected those concerns in her gray swans. Markets are keeping an eye out for any signs that inflation might go up in the US, but Heinel says it may not be all that bad. “A little inflation could be good for the economy,” she says, noting that unless inflation spikes well beyond Fed targets, an uptick could extend the recovery in the US and possibly raise wages. “The real concern,” Heinel says, “is the cost of debt service. With rates where they are, the cost to service the level of debt we have now is still relatively low. If the Fed raises rates too quickly, it will force a repricing of debt.”
If the Fed pauses in response to economic data as it has suggested it might, the US economy could surprise to the upside. In that scenario, inflation would likely continue to move toward Fed targets and concerns about the credit market would wane. If the Fed continues to tighten, deteriorating financial conditions could hit large corporates or banks, triggering a sell-off and putting pressure on liquidity.
Possibility of a Debt-Laden Institution Failing
What happens if a major institution defaults, as Lehman Brothers did in 2008? That was the result of holding too much debt. So maintaining liquidity has emerged as a big theme for allocators this year as they think about how to position portfolios. During its year ahead outlook event with reporters, Commonfund said that it was more focused on managing liquidity in 2019 than volatility.
“The key for our client portfolios is ensuring that there is enough liquidity to cover spending needs year on year,” said Deborah Spalding, Commonfund co-deputy CIO. As a result, the allocator is looking for strategies that are uncorrelated to macro trends in the market, like those outlined by Heinel.
Institutional consultant NEPC is also advising clients to proceed with caution in credit markets. The key, they say, will be to mind duration risk and avoid yield-seeking.
European and Japanese Recovery
There are also a few positive scenarios in the list. Even though investor sentiment toward Europe has been skeptical at best, European corporate earnings are forecasted to rise this year and overall economic performance could surprise to the upside. That could create new opportunities for investors in European equities.
Similarly, increased labor force participation, rising wages and domestic investment in Japan could help Japanese equities outperform this year. These conditions could also make the Japanese yen more appealing for investors.
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