Grey Swans: Low Probability Events to watch for in 2019
In summarizing his career as a derivatives trader in the book The Black Swan: The Impact of the Highly Improbable, Nassim Taleb outlined the concept of an unpredictable financial event with extreme consequences – in other words, a “black swan.” Inherently then, by identifying potential risks to financial markets in 2019 now, these are no longer “black swans.” Instead, we shall call them “grey swans,” events still unlikely to transpire, but if they were to, there would be profound consequences for financial markets.
Here are five “grey swans” to consider as the calendar turns into 2019.
1. Brexit Goes off the Rails, Jeremy Corbyn Rises to Power but the Pound Never Recovers
The UK’s process of exiting the EU – Brexiting – has been messy at best and downright horrifying at worst. A no-confidence vote in December 2018 fended off by UK Prime Minister Theresa May may have bought her some time to try to push through her ‘soft Brexit’ resolution, but there are dissatisfied parties all around. It’s not difficult to foresee a situation where efforts to pass the Brexit resolution are suspended in favor of what’s being called a “People’s Vote,” an effort to hold a second referendum on up-down, yes-no “No Brexit” or “Hard Brexit” outcomes.
Assuming a second referendum is eventually held, it’s easy to envision an outcome whereby Theresa May, despite having a 12-month window of impeachability, decides to step down as prime minister and throw the country back into another general election. By that point in time, after having guided the country through a miserable Brexit flirtation period, the Tory Party would stand in disarray with no clear voice set to unite the Tory Brexiteers and the Tory Remainers. Such disarray would give room for Labour’s Jeremy Corbyn to ascend to the prime minister’s office.
This is not a critique on political economic philosophies, but the fact of the matter is that capitalist financial markets, historically, aren’t pleased when leaders with socialist leanings goes into power. Fears of rampant government spending and ballooning debt and deficits would replace the “Hard Brexit” fears that weighed down the British Pound previously. The fact of the matter is, even if Brexit goes off the rails and is avoided altogether, the damage done to Britain’s soft power is immeasurable, leaving it as an economic backwater with respect to the broader Euroarea. Acting like an emerging market economy on the brink of disaster won’t change anyone’s minds.
2. Emmanuel Macron Loses Power as French President
Throughout the fourth quarter of 2018, the “gilet jaunes” or “yellow vest” protests, engulfed Paris, among other major French cities, in riots. Given that the cause was fiscal in nature – initially, protestors were unhappy with a tax hike related to the Paris Climate Agreement – markets have been keen to see how French President Macron would react. In response to what has become a populist uprising, a desperate President Macro promised to raise wages and step up government spending.
By promising to reverse his tax hike, increase wages, and boost government spending in general, President Macron has promised to deliver a budget deficit, as a percentage of GDP, likely around 3.5%, according to French Budget Minister Gerald Darmanin.
Why does this development matter? The European Commission’s threshold for budget deficit is 3.0% of GDP. Emmanuel Macron has invited outside criticism of his government. As the riots have persisted, the French-German 10-year bond yield spread has increased; meanwhile, their Italian-German counterpart has narrowed since mid-November 2018.
If there is political risk hurting the Euro, it’s coming from France at the moment. There is no reason for the protestors to stop rioting until they get everything they want; Macron caved quickly once, so he probably will again. Accordingly, it is now a risk that the Macron government fails; a no-confidence vote is possible if the riots don’t dissipate. The prospect of a political extremist gaining power in the Euroarea’s second largest economy has previously been a burden for the Euro to carry (see: late-2016 to early-2017).
3. US-China Trade War Goes On, and On, and On…
“Trade wars are good and easy to win.” By now, it’s evident to even the casual observer that US President Donald Trump’s March 2, 2018 statement regarding the perceived expedience and success of his international trade policy was wildly off base. The US-China trade war rages on, even if there is a 90-day period of détente following the G20 summit in Buenos Aires, Argentina on December 1.
Perhaps the key aspect of the US-China trade war is the timeframe on which each negotiating party is operating.
On one hand, Chinese President Xi Jingping isn’t facing an election anytime soon, having just secured his leadership for life after abolishing term limits. On the other, US President Trump just faced a significant defeat in the 2018 US midterm elections, and his political support is on the downswing halfway to his re-election bid in 2020.
As such, for the Chinese, the US-China trade war may simply be a waiting game. A stalemate for a long enough period of time will prove to be more costly for Donald Trump than for Xi Jingping, Chinese strategists reason, given that Trump will face re-election at a time when his political base is feeling the economic sting most intensely. Reports have indicated China’s tariffs are targeting parts of the US that supported Trump politically; to wit, in November 2018, Chinese imports of US soybeans were zero (in November 2017, they were 4.7 million tons).
For all of the market participants hoping to see a quick resolution to the US-China trade war once the calendar turns to 2019, it’s best to tamper down those expectations.
4. Federal Reserve Independence Will Not be Challenged in a Serious Manner
By the end of 2018, the shifting tides of the US economy and requisite responses by the Federal Reserve had drawn the ire of US President Donald Trump. Openly fuming on Twitter regarding the path of interest rate hikes, Trump has made clear time and again that he’s not happy with his decision to install Jerome Powell as Fed Chair, opining that former Chair Janet Yellen may have been a better option.
While some are crying wolf over the perceived threat to the Fed’s independence, the behavior by Trump may not be all that different from his predecessors – he just may be more public about it. In his memoir Keeping at It: The Quest for Sound Money and Good Government, former Fed Chair Paul Volcker recollected an interaction in 1984 with James Baker, then-Chief of Staff to former President Ronald Reagan. Pointedly, Baker told Fed Chair Volcker not to raise rates before the 1984 US midterm elections. This is not an isolated incident in history; former Fed Chair Alan Greenspan and former US President Bill Clinton have, in recent years, reflected on their fractious relationship during the 1990s.
The point is, verbal jousting by the Chief Executive of the United States towards the Chair of the Federal Reserve is nothing new. As tempting as it claim that this is an area in which Trump is overextending his influence, the fact of the matter is that the governance structure of the Federal Reserve is setup to minimize political interference (hence the overlapping term limits between administrations): Congress will have to find a cause to remove Fed Chair Powell from office through a vote and a procedure; Trump cannot.
5. OPEC Dissolves; Russia-Saudi Arabia-US Move towards New Production Bloc
The end of 2018 was a rocky period for energy markets. Amid news that Qatar would be leaving OPEC to pursue natural gas drilling on its own terms, fears of a supply overproduction gripped markets, sending both Brent and Crude Oil down nearly -40% in the final three months of the year.
How quickly things have changed from a decade ago. In 2008, the United States produced, on average, 5.17 million of barrels of oil per day. As we close out 2018, the US is on pace to end the year just short of 11 million barrels per day. This has dramatically altered the production landscape in a short period. Now, in order to cope with this new American reality, we’ve seen Russia and Saudi Arabia – in an agreement that is known as OPEC+ - begin to coordinate energy policy more closely than ever before.
The name of the game at present time seems to be ‘acquire market share.’ Saudi Arabia has made clear that has no serious plans about cutting oil production by itself, instead insisting that other OPEC members share the burden with commensurate output cuts of their own. Russia’s inclusion and growing influence over the decision making of OPEC is simply a matter of pragmatism: if OPEC made cuts but Russia didn’t, would the cuts matter all that much? Since 2016, Saudi Arabia has essentially said that OPEC meetings are pointless without Russia at the table, after all.
As US energy independence rolls forward, it’s reasonable to expect greater coordination between Russia and Saudi Arabia, the other two major global energy producers. But in the event that the lesser OPEC members become stifled by Russian influence over the body’s decision making, OPEC could dissolve itself, sending energy markets into disarray. At that point in time, a coordinated policy among Russia, Saudi Arabia, and the United States could begin to come into focus…a New OPEC.
--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail firstname.lastname@example.org
Follow him on Twitter at @CVecchioFX
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