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Gray Swans for 2018

Published January 30, 2018

While our base case for 2018 calls for steady global growth and tame inflation to support corporate earnings and risk assets, each year we pressure-test those views with outlier scenarios, or what we call gray swans. Thinking about these improbable but not impossible scenarios helps inform the risk-aware approaches we take across our portfolios.

Cyberattacks Rile Markets and Fake News Compromises Big Data

When the credit monitoring firm Equifax notified 143 million Americans last September that their most private personal and financial details had been hacked, the markets shrugged off one of the most serious data breaches ever. But the latest Intel computer chip vulnerabilities affecting billions of users have reinforced just how susceptible our digitized lives and capital markets have become. The market chaos caused by temporary flash crashes is unsettling, but a comprehensive cyberattack could cause more lasting market damage. A related vulnerability is the proliferation of spurious information on social media. Apart from increasing political and social polarization and undermining trust in institutions, this “fake news” can be aimed at investors more directly. Last year the SEC took action against a Southern California company, Lindigo Holdings, for paying writers, using false names and profiles, to generate hundreds of “bullish” online stories to manipulate individual stocks. This could be the same kind of false information a growing number of big-data-driven hedge funds are scraping to find an edge. The intersection of high-frequency trades and targeted fake news could trigger outsized market movements.

Protectionism Stifles Growth, Feeds Inflation

President Trump’s first tumultuous year in office left little time for making good on his campaign promises to fix the “bad deals” he considers NAFTA and trade with China to be. Other than withdrawing from the Trans-Pacific Partnership (TPP), the only other actions have been specific tariffs targeting lumber, solar panels and washing machines. But 2018 could be the year Trump gets serious about protectionism. While NAFTA negotiations have been contentious to the point that Canada is reportedly bracing for the US to announce withdrawal, as we have noted before,1 there are strong vested business interests in the US to uphold the agreement, many based in states that voted for Trump. US–Chinese trade is different, as there is virtually no pro-China constituency in the US, whereas NAFTA has many friends in state capitals. Any significant move to impose tariffs on China could ignite a trade war that would risk stifling growth and raising consumer prices. Serious discussions with China have yet to begin, although several anti-dumping cases are reaching a critical stage. In its veiled warning about ending purchases of US Treasuries, China seems to be bracing for tough times ahead. In this scenario, US small-cap equities less dependent on international trade would likely fare better.

Emerging Market Hot Spots Trigger Sell-off

Solid gains in emerging market (EM) equities in 2017 masked country-specific divergences that could spell trouble in 2018. The Mexican peso declined 7% in the fourth quarter, despite central bank attempts to defend the currency with direct intervention and 425 basis points of rate hikes. Mexico stands to lose the most if the NAFTA negotiations fail and its currency will suffer accordingly. The left-leaning AMLO party currently leads in polls for the presidential election on July 1, on a populist agenda of income redistribution that is unlikely to be market-friendly. Turkey is perhaps the most vulnerable to a sudden stop in capital flows, which largely finance its widening current account deficit. As the country has pivoted away from the European Union (EU) and the US, the Turkish lira has fallen to new lows and inflation hit 13% in late 2017.2 Rising oil prices and tighter liquidity would also worsen Turkey’s deficit. South Africa is another potential trouble spot. Despite facing one of the world’s lowest growth forecasts, South Africa’s central bank will likely need to tighten policy to combat stubbornly high inflation and any resumed pressure on the currency. A crisis in any one of these countries could spark a sell-off in EM debt and equities.

Europe’s Bear Case: Populism Resurges, EU Faces Collapse, Dollar Reaches Parity

Disagreement over European Union (EU) reform could collapse Germany’s grand coalition, forcing another election in which the nationalist Alternative for Germany party might pick up an even larger share of votes than in September’s election. Similarly in Italy, the populist Five Star Movement could form an anti-EU government after winning an overwhelming victory in March. Poland’s nationalist government could decide to follow Britain’s lead to leave the EU, setting off an exit contagion across the EU periphery that would pose an existential threat to the EU. As the US continues to boom, European growth would roll over. Core EU inflation would drop below 1%, the European Central Bank (ECB) would extend its quantitative easing (QE) program, and capital outflows would ensue, driving the euro down to dollar parity. Investors looking to hedge against this scenario could create a barbell of US and EM assets, while avoiding the EU and euro-denominated assets.

Europe’s Bull Case: Inflation Speeds Up, EU Political Risk Diminishes, US Falters

We could also envision a scenario in which Europe performs significantly better than the US, which could drive the dollar lower as investors turn to European assets. A sharp rise in European corporate earnings could push growth and inflation sharply higher. At the same time, successful resolution of Germany’s coalition talks and a positive Italian election outcome would reduce Europe’s political risk premium. Depending on how quickly inflation ticks up, the ECB could conceivably bring forward rate hikes into 2018. Meanwhile, if Trump were to start a trade war with China, China could retaliate by selling short-term US debt and moving its reserves to the EU. The US dollar could under this scenario break 1.40 euros. In this case, the appropriate hedge would involve a barbell of EU and EM investments, without the US and dollar-denominated assets.

US Bull Case: Productivity Growth Resuscitated as Tax Cuts Yield Stronger-Than-Expected Boost

While our base case is for another positive year for the US economy and stock market, we might also finally see sluggish productivity growth move sustainably higher as a result of the corporate tax cuts. Lower taxes combined with the option to expense capital spending immediately could serve as a powerful incentive for firms to upgrade productive capacity and boost labor productivity — which is especially important when the labor market is operating at full employment, so finding qualified workers has become more difficult. Such an injection of capital could extend the “Goldilocks” environment. While this 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, as higher productivity restrains inflation and boosts potential growth. US equity investors could continue to ride the wave.

US Bear Case: Runaway Inflation, Higher Volatility, Rerating and “The Great Unwind”

Of all the gray swans, a persistent surge in inflation could have the most serious cascading effects. With US unemployment at just 4.1%, long dormant wage pressures could finally emerge as workers demand a greater share of company earnings. Fiscal stimulus from the US tax reform bill is anticipated to boost real GDP by 0.3% and put further downward pressure on unemployment. A 10% decline in the US dollar in 2017 has increased the cost of imported goods. And oil prices have moved to their highest levels since 2014, boosting global inflation pressures. The New York Fed’s Underlying Inflation Gauge (UIG), which tracks inflation persistence, currently sits at 2.9%,3 a full percentage point above the latest Fed projection4 and at a 10-year high (see Figure 1). US 10-year breakeven inflation rates, which measure implied inflation expectations from real and nominal Treasury yields, are also trending higher.

A sustained surge in inflation might push market pricing of future rate increases ahead of the Fed’s trajectory, pulling up longer-term US interest rates. An abrupt tightening in financial conditions would disrupt the comfortable balance of low rates and moderate growth that has kept volatility subdued (see Figures 2 and 3).

If inflation causes volatility measures to spike and stay up, not reverse as quickly as before, we might see the beginning of the Great Unwind. We should watch for changes in the asymmetric reaction of the market to episodes of higher volatility — particularly in strategies such as risk parity, which set portfolio exposures to target a constant level of volatility and so have taken larger and larger risky positions as realized volatility has fallen. Should these strategies stop using volatility reversals as buying opportunities, then the great unwinding of trades that benefit from low volatility would be all the more disruptive.

While this is far from our base case, it is also conceivable that higher-than-expected inflation might cause the Fed to overshoot on rate tightening, choking off growth while inflation continues to climb higher. This would be the worst of all possible scenarios: stagflation. Suddenly US Treasuries and gold would look quite attractive again. In this scenario, inflation-hedging assets such as TIPS,5 natural resource equities and commodities might be the best performing assets of 2018!

1See SSGA IQ Insights, “Have the Protectionist Risks of ‘America First’ Been Priced In?” by Elliot Hentov, February 2017.

2Source: Turkish Statistical Institute, Tradingeconomics.com as of January 3, 2018.
December reading published January 12, 2018.
Median 2018 forecast of Personal Consumption Expenditure (PCE) inflation by Federal Open Market Committee members, December 2017.
Treasury inflation protected securities (TIPS) protect investors from the negative effects of inflation because the par value rises with inflation, while the interest rate remains fixed.


Chicago Board of Options Exchange (CBOE) Volatility Index (VIX): An index constructed using the implied volatilities of a range of S&P 500 options to forecast 30-day volatility.  

Merrill Lynch Option Volatility Estimate Index (MOVE): An index constructed using the implied volatility of one month Treasury options.         

Realized Volatility: A measure of the historical volatility of the price of an asset.

S&P 500 Index: A market value weighted index of 500 stocks that reflects the performance of a large cap universe made up of companies selected by economists; the S&P 500 is one of the common  benchmarks for the US stock market, and investment products based on the S&P 500 include index funds and exchange-traded funds.

Stagflation: A period of economic stagnation accompanied by inflation.


The views expressed in this material are the views of Rick Lacaille and Lori Heinel through the period ended 1/22/2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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