by Aly Somani, CFA, Portfolio Manager, SLGI Asset Management Inc.
Recall our insights last year on "grey swans": observable, potentially rare, yet highly impactful financial events. 2023 saw several materialize including the business failures and insolvencies of certain regional U.S. banks. Silicon Valley Bank, Signature Bank of New York and First Republic Bank faced collapse, marking three of the largest bank failures in history. Additionally, Europe’s Credit Suisse, a prominent global investment bank, teetered on the brink of collapse until Swiss authorities intervened.
Looking ahead, here are some "grey swan" candidates we're monitoring to ensure portfolio resilience:
Scenario #1: Another wave of inflation
Inflationary pressures rebound and a second wave of inflation hits the global economy; central banks avoid cutting interest rates and consider a different rate path.
Geopolitical risks are now rampant given multiple hot and cold wars globally. If these risks start to materialize, supply chains may suffer and the price of oil and other key commodities may surge.
Additionally, Chinese stimulus efforts along with ongoing highly expansionary U.S. fiscal stimulus could also lead to an upswing in global demand. We also know that wage inflation presently remains elevated and excess consumer savings accumulated through the pandemic may not yet be fully spent.
Potential market impact
Markets lose confidence in the ability of central banks to tame inflation; bond yields erupt higher, leading to potential concerns around a future U.S. fiscal debt crisis. Volatility rises and riskier assets suffer accordingly while the yield curve significantly re-steepens as investors require greater compensation to hold bonds.
Investors flock to commodities and natural resource stocks. Equity market leadership rotates from favouring larger cap and technology-dominated issuers to traditional economy and/or mid-cap companies.
Scenario #2: Rates remain elevated
Despite inflation weakening, the U.S. Federal Reserve chooses not to cut interest rates, or cuts far less than initially expected due to a U.S. economy that remains resilient.
U.S. fiscal spending continues with the country expected to run a deficit nearly on par with last year. Such a large fiscal deficit is a rarity with unemployment at historic lows. This suggests U.S. interest rates may deserve to be unusually elevated given fiscal debt risks and as excess spending works through the economy.
Also, with respect to the labour market, companies may be reluctant to let go of employees given a potential scarcity of labour that has developed post-pandemic driven by accelerating baby boomer retirements, subdued labour productivity, a lack of accessible childcare and declining birth rates.
Potential market impact
Bond yields move somewhat higher as investors revisit their assumption of the appropriate policy rate. Companies that are highly leveraged or have weak balance sheets experience continued weakness or falter.
U.S. stocks and credit spreads continue to rally, albeit with limited upside and narrow breadth given the increasing yield available in lower risk assets such as cash and government bonds. Risk assets elsewhere are subdued (and the past year’s trend of “American exceptionalism” continues). U.S. bond yields remain elevated versus the rest of the world and the U.S. dollar strengthens.
Scenario #3: OPEC+* Nations grow more uncooperative
OPEC+ loses key members and begins to disintegrate as discord between Saudi Arabia and other key oil-producing countries grows.
Behind this potential scenario is the backdrop that global oil demand is expected to grow at a reduced rate in 2024 compared to prior years. Saudi Arabia increasingly stands alone in its low tolerance for oil prices falling materially below US$80 per barrel of crude oil (approximately the level needed to balance its fiscal budget). Russia has been inconsistent in adhering to production cuts and has been strategically vague in its communication. Meanwhile, the United Arab Emirates has repeatedly requested a higher oil production quota as it seeks to monetize its oil reserves more quickly given its increasingly diverse economy.
Potential market impact
OPEC+ loses much of its power in the control of global oil supply, creating volatility in energy markets. Excess production and an initial price war leads oil prices to weaken and causes the material decline of energy and oil company shares. The drop in oil prices increases disinflationary forces, helping support central banks to normalize interest rates. Investors continue to favour technology and other non-resource stocks while bonds rebound sharply.
The drop in oil prices also stimulates major net oil importers (such as the Eurozone, Japan, China and India) while hurting major net oil exporters (such as OPEC+ member countries and Canada).
Scenario #4: Challenges for private assets increase and spread
Failures increase in the private asset space with commercial real estate and other similar alternative investments coming under increasing downward pressure.
If bond yields do not significantly decline this year, private asset financing (including commercial real estate loans) may become increasingly uneconomical. Lower relative returns in private assets are also coming at a time of rising labour and building costs (as well as a potentially structural shift in end-user demand, that has arisen post-pandemic, when it comes to assets such as commercial real estate). These forces may put downward pressure on private asset valuations. Public pressure could also arise to force the U.S. Securities and Exchange Commission or other regulators to step in to reduce the spread in valuations between modeled private asset prices and listed/public market comparables – further eroding investor appetite for private assets.
Potential market impact
Regional banks and other key lenders/investors in private asset classes could see their valuations decline as fears over their exposure to private assets increase. A corresponding drop in regional bank multiples may cascade to larger cap financials and eventually the broader market. A similar cascade could conceivably develop in broader real estate as commercial real estate valuations decline.
Among the most sensitive investors to private market valuations are global pension funds and similarly large institutional investors, which have raised their allocation to private assets dramatically in recent years. As liquidity needs arise for these investors, a markdown of their private investments could spillover into public markets and further diminish investor confidence.
The risks listed above may seem remote. And they may not dominate the minds of risk management teams as they are perceived to have a low probability. But understanding their potential impacts helps us deal with unobvious risks. We believe factoring these unlikely risks helps us build resilient multi-asset portfolios.
*OPEC+ is a larger group which includes OPEC nations in addition to Azerbaijan, Bahrain, Brunei, Brazil, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan and Sudan. OPEC refers to the Organization of Petroleum Exporting Countries and includes Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon, Angola, Equatorial Guinea and Congo.
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SLGI Asset Management Inc. is the investment manager of the Sun Life family of mutual funds. Sun Life Global Investments is a trade name of SLGI Asset Management Inc., Sun Life Assurance Company of Canada, and Sun Life Financial Trust Inc., all of which are members of the Sun Life group of companies.
© SLGI Asset Management Inc. and its licensors, 2024. SLGI Asset Management Inc. is a member of the Sun Life group of companies. All rights reserved.
Source: "(6) Four grey swan events that may shape markets this year | LinkedIn." 28 Feb. 2024, www.linkedin.com/pulse/four-grey-swan-events-may-shape-markets-year-nm9ze/
