A Chinese currency devaluation, a spike in oil prices and a longer-than-anticipated US cycle are among six ‘grey swans’ or outlier scenarios that could challenge markets and investors in 2019, according to State Street Global Advisors’ Lori Heinel.
Heinel, deputy global chief investment officer, said the firm expects global growth to slow this year against a backdrop of risks that include further tightening by the Federal Reserve and heightened geopolitical tensions caused by trade wars and the rise of populism.
In such an environment, the asset manager believes that the US will likely outperform other regions in 2019 with earnings buoyed by the remnants of the Donald Trump’s tax cuts, low unemployment and inflation contained.
However, there are a number of ‘grey swans’ that could challenge the firm’s base-case scenario, as explored below.
Chinese devaluation
While the US-China trade spat has rumbled on, much of the focus has been on what it might take for both parties to come to an agreement.
However, a sudden escalation could see Chinese authorities turn to one of the most powerful weapons in its armoury: the renminbi.
Heinel said its first ‘grey swan’ is that following years of careful management, China could allow the currency to depreciate sharply against the US dollar.
Performance of Chinese renminbi vs US dollar over 5yrs
Source: FE Analytics
However, she said such an outcome is unlikely as both the US and China have an interest in maintaining a weaker dollar.
“China has been unofficially managing its currency to regulate its trade and mitigate the risk of capital outflows, so dollar appreciation could be a problem,” she said. “The US, meanwhile, does not want the dollar to strengthen significantly against the yuan as it reduces the effects of US tariffs on Chinese goods.”
The State Street strategist said China is keen not to be viewed as a currency manipulator, although it could change tack if the trade dispute worsens.
“It could decide to stop trying to stabilise the yuan and allow it to plunge against the dollar,” she said. “This would further offset the impact of tariffs on Chinese exports to the US, but could easily spook already nervous financial markets and trigger capital flight. The corresponding increase in dollar strength could hurt emerging markets as an asset class, perhaps even more than in 2018.”
Oil rebounds to $90 a barrel
The next ‘grey swan’ comes in the shape of an oil barrel, with Heinel highlighting the possibility of a sharp rebound in prices.
“Consensus suggests that the oil price is likely to trade within a range ($50-$67) in 2019,” she said. “Many believe it could go lower still as the US, now the world’s largest producer, ramps up production, disruptions to supply from Iran and Venezuela prove less severe than anticipated and concerns mount over slowing global growth.”
However, there are a number of factors that could drive up prices over the longer term, including tighter supply as a result of production cuts and growing demand driven by demographics.
Performance of Bloomberg Brent Crude Sub over 3yrs
Source: FE Analytics
“While countries concerned about climate change want to move away from fossil fuels and China, whose tectonic rise fuelled a commodity super-cycle, is starting to adjust to more normal growth levels, we are only a few years away from talk of ‘peak oil’ and predictions of prices reaching $200 a barrel,” she said.
“While that looks out of reach for now, displacing oil as the mainstay of the global economy with electrified transport and heating will take time.”
A major institutional default
“After a decade of easy money, leverage has increased across public and private companies, exposing the global economy to a greater risk of major credit events in an era of rising interest rates,” said Heinel.
“If the Fed continues to tighten monetary policy, then financing conditions could deteriorate, potentially spurring a major, and possibly systemic, default at one of the larger corporates or banks.”
Such a move would harm confidence in the late-cycle credit markets and trigger a flight from sectors with the greatest levels of leverage.
“While cracks have begun to emerge at this late stage of the credit cycle, they are not canyons yet, and valuations are no longer rich after spreads widened in December,” she added. “However, credit events tend to start small and then build, so it is worth keeping an eye on larger, more highly-levered companies especially where their business models may be under pressure.”
Europe surprises to the upside
One ‘grey swan’ event that could be positive for markets is a surprise to the upside from Europe against a “dismal” consensus outlook.
“While analysts expect earnings to rise by around 8 per cent, sentiment towards the region as a whole is weak, driven by political uncertainty within Europe and the upheaval caused by Brexit,” said Heinel. “Europe is also exposed to the US-China trade dispute as it relies more heavily on exports to drive growth due to unfavourable demographics and the structural imbalances created by monetary union.”
She added: “While the US economy currently appears to be in a healthier state at present, if Europe does perform significantly better than the US in 2019, this could drive the dollar lower as investors turn to European assets.”
US cycle extends much further than consensus expects
While December’s sell-off seemed a disproportionate reaction to a well-signalled interest rate hike by the Fed, the strength of it showed how worried investors are, said the State Street strategist.
As such, a new approach to interest rates and a resolution of the US-China trade stand-off combined with other positive data could see the US cycle extend much further than anticipated.
Performance of S&P 500 over 10yrs
Source: FE Analytics
“With the US economy still expanding if not over-heating, there is no obvious catalyst for a recession,” she said. “Indeed, it is possible for countries to go for long periods without experiencing a significant contraction.
“For example, Australia has not had an official recession in 27 years thanks in part to the exogenous effects of the commodity super-cycle.”
She added: “While this extended cycle scenario would be positive for corporate profitability and equities, it could be negative for bonds if yields move up to reflect expectations of a higher neutral rate.”
Japanese inflation breaks out and Bank of Japan is forced to hike
The final ‘grey swan’ would be an outbreak of inflation in Japan after years of deflation, which almost nobody would be prepared for, according to Heinel.
She said two decades of battling deflation has resulted in a more accommodative bias at the Bank of Japan and among investors. However, rising wages and increased fixed domestic investment might be starting to have an impact.
“Central banks around the world appear to have grown anxious about extending extraordinary monetary measures ad infinitum and are trying to wean their economies off easy money,” she said. “Even Haruhiko Kuroda, head of the Bank of Japan, has signalled that Japan is no longer in a phase where ‘large-scale policy’ is considered the best way to fight deflation.
“However, he is likely to be acutely conscious of not repeating past mistakes and therefore will be in no hurry to raise rates.”
As such, real interest rates are likely to remain negative for the time being despite increasing inflationary trends.