At State Street Global Advisors, our definition of a Grey Swan is a scenario that typically has a very low likelihood of occurring, yet carries the risk of broad investment implications. If a Grey Swan event were to occur, it could meaningfully shift our outlook and our portfolio positioning.
That the future is always uncertain is a given, yet thinking about scenarios that diverge from a base case helps inform the risk-aware approaches we apply across our portfolios. We believe that contemplating such alternative scenarios should form a part of investor thinking as it allows for quicker reaction to revise portfolio allocations should these or similar situations materialize. And despite widespread perceptions to the contrary, these need not necessarily be negative. By teasing out possible outcomes at the outset, investors should be better placed to determine whether and how to implement any hedging strategies. Whether or not any such eventualities come to pass, there is always value to be gained from pressure-testing positions and expectations.
For insight on how we expect 2024 to unfold, our base case views are reflected in our 2024 Global Market Outlook. Yet we have also identified several alternative scenarios — our Grey Swans — that could develop and we assess their potential investment implications.
The US equity market, as measured by the S&P 500 Index, ended 2023 within shouting distance of a record high. However, this somewhat disguises the extent to which a small cohort of stocks has driven returns. The index is currently experiencing an all-time high in terms of concentration, with the top ten stocks comprising about 32% of this benchmark. Seven stocks (the Magnificent Seven)1 contributed 65% of the S&P 500 Index’s return in the year.2 Earnings growth was also centered on those same stocks, as the rest of the market had negative growth in 2023 (Figure 1). Such disparities inevitably draw attention and there are always going to be divergent opinions around the growth of such behemoths, the perception of a concentration of wealth, and the potential for market distortion. But what if regulators concluded that one or more of the Magnificent Seven needed their wings clipped?
In this scenario, the concentration of massive power among the few reignites antitrust discussions, on both the campaign trail and in Congress. Regulators increase their scrutiny of the Magnificent Seven’s potential anti-competitive business practices, abuse of market dominance, and the resulting harm such concentrated power could have on inflation, consumers, entrepreneurs, and economic equality. Legal cases work their way through the judicial system with the power to set a negative precedent on antitrust violations by Big Tech companies.
Yet this is not just a US-specific trend, as there is global pressure as well — evidenced by the European Commission’s antitrust case against Apple that may lead to a fine of as much as 10% of the firm’s annual sales.3 There is also the looming implementation in 2024 of the European Union’s Digital Markets Act, a list of rules that has the potential to impact Big Tech’s profitable operations.4
Increased regulatory pressure alongside more antitrust cases may impair the Magnificent Seven’s operational efficiency and business models, reducing investor enthusiasm that the entities that exist today will remain contiguous and as profitable in the future.
If so, look for not-so-magnificent returns in 2024 from this cohort, leading to a change in style (the Magnificent Seven make up more than half of the S&P 500 Growth Index)5 and sectoral leadership. This could also change regional leadership, as non-US stocks may be able to outperform US benchmarks if there is weakness at the top of the US markets — reversing the trend in 2023 where the US beat non-US by 11%.6
At a time when markets are anticipating an easing of tight central bank policies and a soft landing for the global economy, this Grey Swan speculates on how credit developments in the non-bank financial sector1 could portend a nastier outcome. Large parts of this rapidly-growing sector, which includes venture capital, private equity and commercial real estate, alongside mutual funds and insurance companies, are opaque, involving hidden leverage as well as liquidity mismatch.7 And it is here where this swan may begin to take flight.
Currently, private and public debt levels are at record highs and financial conditions are extremely tight. Alongside the sharp rise in interest rates since the start of 2022, central banks are in the process of shrinking their balance sheets. Money supply has been contracting and bank lending standards have become significantly more restrictive.
With much riding on a rollback of rate hikes, a stalling or reversal of the disinflationary trend could re-harden the “higher for longer” scenario with serious credit losses then materializing. To get a sense of the potential size of any shock, data for Bank for International Settlements (BIS) reporting countries show bank claims on the non-bank financial sector at $11.8 trillion at the end of June 2023 (see Figure 2). Private market deals reached a multi-decade high of around $500 billion globally at the end of 2021.8
Private equity and private credit funds have also had a significant impact on corporate borrowing. With borrowing costs up, highly-leveraged companies could face problems with debt refinancing and repaying their debt, a large proportion of which is estimated to mature within the next three years.9 Meanwhile in commercial real estate, where shifting working patterns have led to a reduction in required office space, further asset value declines would worsen investors’ woes. A real estate downturn could trigger considerable withdrawals from REITs, as could corporate credit defaults from mutual funds and ETFs. The opaqueness of some markets could generate panic that ripples across other sectors at just the ‘wrong’ moment.
The blowback on banks would be exacerbated by ongoing poor governance and controls in parts of the industry, despite huge regulatory effort to overhaul the banking system since 2008.10 Bank supervisors have already indicated they are not entirely satisfied in how well some banks manage their counterparty risk and there are also concerns around how some control and limit their risk concentrations. Moreover, different jurisdictions and a lack of common criteria can make overexposure to a single counterparty or connected exposures harder to identify.11
Amid market disruption, intense speculation over the systemic risk from bank exposures could drive a “dash for safety” with a resultant dumping of debt securities and downward price spirals in those segments under most stress. If dealers’ balance sheets become “used up” due to rapid and high volume market moves, this could also mean some financial markets cease to function.
While the geopolitical landscape at the start of 2024 is marked by a number of concerns, markets have been relatively unruffled by their development over the last years (and months), with investors typically tending to look through and beyond such threats. Yet what if that were to change significantly in the coming year? The geopolitical tensions with China, and wars in Ukraine and the Middle East reverberate throughout 2024, creating more episodic events, and putting an already fragmented global economy on high alert. A cascade of elections around the globe adds to geopolitical disruptions to oil production and shipping, with worries over additional supply risks widening the risk premium in commodities. Oil prices march higher, but in a step-change formation where prices first level off before charging ahead after the unfolding of each subsequent escalation.
In this scenario, global inflation rises without immediately implying a growth shock, so central banks are quick to pivot, reversing course on previously-signaled dovish flight paths. Rattled by this turn of events, the Federal Reserve Board’s (Fed) ‘dot plot’ of members’ expectations points toward higher policy rates as the Fed calls a halt to rate cuts. In doing so, investors are caught by surprise, with equities succumbing to a sharp drawdown of over 20%. Against this backdrop, the US dollar benefits from two simultaneous forces: higher relative yield expectations given its status as a major oil producer; and a flight to quality, providing a significant bid for the greenback.
The US dollar takes out 2002 highs, an approximate 16% move from 102.5 today12 and zeroes in on the 1985 highs, representing a whopping 30% rally. The primary risk to the global system is once again inflation. In contrast to previous oil price shocks, oil is now more closely correlated with a stronger dollar, amplifying the inflationary effect on the global economy amid tightening financial conditions. Oil approaches highs of $140/barrel, a rally of more than 70%.13
At the same time, with the threat from geopolitical instability growing, gold breaks higher to surge past the high of $2152/oz achieved in December 2023, as the precious metal glitters in the face of risk aversion and inflation. As we close out on the year 2024, the US election delivers another injection of upward momentum to gold traders as the US fiscal position is temporarily flattered by ‘safe haven’ flows even as the structural fiscal path continues to worsen.
As the end of 2023 drew near, extreme negative interest rate differentials had weakened the Japanese yen to about Y150/US$ before recovering slightly. While the US Fed has raised interest rates by 525 basis points (bps) since 2022, the Bank of Japan (BoJ) has maintained a negative policy rate throughout, although it has tweaked its yield curve control (YCC) policy. But this is a peak rate differential moment; the delta is bound to shrink dramatically over the coming year. But what if the rate gap narrowed by far more than markets anticipate?
Broadly speaking, we expect the Fed to deliver 150 bps worth of cuts in 2024 (without a recession) and to match that in 2025. The magnitude and timing of Fed cuts would be augmented and brought forward should a recession actually take hold (to which we assign a 25% probability). So far, so unremarkable. But then, after a very timid start to the policy normalization process, the BoJ exits negative interest rates early in 2024 and embarks on a much more aggressive tightening campaign than previously anticipated. The confidence-sapping deflation era is finally overcome as wage negotiations yield robust outcomes (aided also by government tax incentives) and a virtuous cycle takes hold. Under pressure from rising labor costs and under threat of delisting following the implementation of new rules for firms listed on the Tokyo Stock Exchange, Japanese companies embrace a more aggressive pricing approach. Higher pricing power in parts of the economy breeds higher pricing power in others. Capital flows are reversed as investors identify opportunities and Japanese companies and individuals repatriate funds for investment at home as the yen carry trade falters. With inflation sustained near 2.0%, the BoJ raises policy rates by 150 basis points over a period of 18 months. The yen appreciates dramatically and breaks through 100/USD.
While such a scenario would entail the yen appreciating by more than 30% in 2024, it is worth noting that our FX team’s estimate of yen fair value (based on long-term PPP14 models) is in the neighborhood of 76. So the yen at 100 is not nearly as extreme an outcome as it may seem at first glance. In fact, it would simply mark a return to the average that prevailed in the decade pre-Covid.
The low growth, low inflation world that defined the years between the Global Financial Crisis and the pandemic was abruptly replaced by a reopening growth boom and a supply-exacerbated inflation spike. A new broadly-shared concern soon emerged though — that reshoring and the green transition would usher in an extended period of low growth and above-target inflation, essentially a mild version of stagflation. In this Grey Swan, the reality turns out to be far more constructive as a convergence of forces deliver an unexpectedly strong and lasting productivity and growth boom.
In this scenario, fears around green transition and deglobalization prove overdone. After some initial challenges as the world adjusts to a faster transformation timeline forced by the war in Ukraine and US-China tensions, a new equilibrium is found. Energy policy globally makes a subtle but important adjustment toward energy solutions rather than merely energy transition. A holistic approach to ensure continuity and resilience of supply is implemented with a hugely positive impact. Meanwhile, deglobalization fears prove wildly overdone as new supply centers like India and Latin America emerge at scale, fueled by heavy investments. The world is far from struggling with insufficient productive capacity.
Rapid technological advancements, specifically in artificial intelligence (AI), have compounding positive effects on productivity across the economy, but especially in service industries. Product development timelines across industries are dramatically reduced. Healthcare and education are transformed by broad AI implementation. Labor productivity soars, inflation is kept well under control, real incomes surge, and growth enters a sustained higher trajectory.
For investors, the implications of this scenario unfolding would likely drive a focus on growth assets, in particular those that are leveraged to the AI boom and green transition. Technology companies continue to lead, US exceptionalism continues. Areas of the market that may prove less appealing in this development include bonds, TIPs, and commodities.
The evolution of the digital assets space has continued apace despite the extreme volatility experienced from time to time in parts of the market. In our final Grey Swan, we imagine the embrace of the technology by a well-recognized artist energizing retail investors to accelerate their adoption of digital assets as a means to invest and trade in experiences. Other digital influencers and celebrities swiftly recognize the power of these technologies to broaden their reach, take ownership of, monetize, and align their brands with their core values. This leads to a period of disruption for the business models in entertainment industries, and knock-on effects for financial services. Smaller artists get to bypass traditional industry infrastructure and raise funds through tokenized offerings, leading to a more decentralized and equitable distribution of profits in the industry.
As this movement gathers momentum, fans start to think of themselves more as asset owners and traders, connecting directly with each other and artists. A virtuous circle of greater transparency and trust, and lower costs and complexity emerges, creating a tradable asset class where individuals can buy, sell, or trade their ownership or access rights to experiences easily and efficiently, valuing exclusivity and community over traditional investment returns. Fractional ownership of experiences through digital assets democratizes the marketplace as fans with smaller budgets get to participate.
Financial services providers, particularly those focused on retail, see the opportunities of digital assets as a diversifier from traditional asset classes, and a way of providing greater personalization of their clients’ portfolios.
In this Grey Swan scenario, the growing adoption of digital assets has a tsunami effect. Most directly, this new form of engagement and monetization bypasses traditional intermediaries, such as concert venues, ticket sellers, entertainment labels, and streaming platforms, leading to rationalization and transformation.
Traditional financial institutions scramble to create valuation models for non-financial attributes such as unique experiences, and explore ways to integrate digital assets into their products and services. They launch funds that invest in these assets, while developing approaches for incorporating them into model portfolios. This effectively moves the intrinsic value of experiences through the collectibles arena and into mainstream finance. New disruptors emerge to cater specifically to this growing market as digital assets become legitimized as a medium of exchange, and a store of value.
Following retail, institutional asset owners seize on this new and growing asset class as a way to diversify portfolios and gain exposure to new sources of growth. This leads to a revaluation of traditional assets, a recognition of the possibility to securitize and democratize anything of value, and a growing demand for new investment products that incorporate digital assets.
Figure 6: The Transition from Internet Renters to Internet Owners
|Platform Operators Create
|Platform Users Create
|Platform Users Create
|Platform Operators Govern
|Platform Operators Govern
|Platform Users Govern
|Platform Operators Own
|Platform Operators Own
|Platform Users Own
|Platform Operators Profit
|Platform Operators Profit
|Platform Users Profit
Source: BofA Global Research.