Grey swans emerge globally with the dawn of a Trump era

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SINGAPORE (Jan 24): Tail risks, no matter how unlikely, are not entirely implausible, exceptionally rare, or unknown. Despite falling short of base case expectations, the improbability does not undermine their potential impact to financial markets.

State Street Global Advisors (SSGA) therefore calls such scenarios “grey swans” rather than black, and believes investors should be thoroughly reviewing their portfolios for adequate downside protection against them.

In the investment management unit of State Street Corporation’s IQ Insights report for the month of January, senior portfolio manager, investment solutions group (ISG) Lorne Johnson has identified a number of grey swans for 2017.

China, for example, tops SSGA’s list in this case for failing to control its currency and financial markets or to “manage an orderly slowdown” of its economy.

Against a weaker backdrop and a stronger US dollar, Johnson thinks the renminbi (RMB) will depreciate much faster if the People’s Bank of China (PBOC) stops defending the currency in its retaliation to president Donald Trump’s labelling of the republic as a “currency manipulator”.  

(See also: What happens if Trump declares China a currency manipulator?)

“Given the shift to a more reflationary environment and greater uncertainties around Sino-American political and economic relations in 2017, we see a bigger risk to China’s ability to steer a smooth path, with potentially dire implications for other emerging markets,” comments the senior portfolio manager.

As Trump administration’s policies thus far “have not been forthcoming”, he anticipates an even more uncertain outlook for Emerging Market (EM) assets, exacerbated by improving growth and inflation prospects in the US which will lead to a more aggressive pace of interest rate hikes.

(See also: The most popular investor picks for Emerging Markets in 2017)

Another grey swan is the event in which global trade wars break out from Trump’s actions to force changes in trade relationships.

According to Johnson, countries that see their economic interest in jeopardy, particularly China, could choose to “go on the offensive” by using their own protectionist policies to support uncompetitive or obsolete industries, thus retaliating by placing restrictions on goods and services produced by US firms that are competitive US exporters.  

(See also: MAS warns of ‘disastrous’ effect of trade conflicts)

“Not only would this negatively impact shareholders, employees and customers of those firms, but essentially the uncompetitive parts of the global economy would be propped up at the expense of competitive areas, with aggregate social welfare paying the price,” he cautions.

Other grey swans identified by SSGA include the Fed moving faster to tighten financial conditions “in a way to trip up markets, slow down consumer spending and cause a further surge in the US dollar” to keep up with higher-than-expected growth or inflation in 2017; the ramping up of global inventories resulting from any one country’s non-compliance with the voluntary cuts to global prices; as well as the escalation of cyber terrorism into cyber war to weaken local infrastructure or confidence in global markets.

Johnson adds that with a packed electoral calendar this year, the risk of “another shock to the European integration from the ballot box” may soon become a reality as well.

(See also: Europeans are waiting for these 5 upcoming elections with bated breath)

To guard their portfolio against these grey swans, SSGA recommends investors opt for strategies with built-in rebalancing triggers tied to volatility, or strategies that aim to manage volatility by using either rules-based or alpha-seeking active management.

“Many pressure points that were evident to us at the beginning of 2016 are still in play for 2017, and the Trump administration presents a plethora of new opportunities and risks for markets,” says Johnson.