Five Grey Swans That Could Swing Markets

The Fed Lets Inflation Run Hot

For years, global central banks have stressed their commitment to meeting their respective inflation targets, and for years they have failed. Almost 10 years of monetary stimulus has not meaningfully affected actual inflation rates and inflationary expectations continue to sit stubbornly below target.

More recently, that commitment has been increasingly expressed in relation to a “symmetric” inflation target, implying some inflation overshoot during economic expansions to compensate for anticipated shortfalls during recessions or periods of soft growth. However, having seen central banks failing to bring inflation to 2.0%, why would investors have any more confidence in their willingness to push inflation above that level?

We could construct a scenario where US inflation exceeds target and the Fed not only lets that happen but the magnitude of the tolerated and desired overshoot takes investors by surprise.

Inflation has been firming with headline consumer price index (CPI) crossing 2.0% and the core personal consumption expenditure (PCE, the Fed’s preferred measure) moving higher. We see multiple triggers for higher US inflation this year, ranging from tight labor markets, technical factors, higher oil prices and a weaker dollar, to name the most important. The Wage Rigidity Index of the San Francisco Fed already reflects broader wage increases across the US population. As shown in Figure 3, the percentage of US workers experiencing flat wage growth has dropped dramatically from early 2018 and for the first time during this expansion has touched the 2005 highs.

In our scenario, the Fed reacts completely differently from 2017-2018, when a tightening labor market triggered worries of overheating and a series of sustained rate increases. Here, the Fed re-energizes its commitment to its symmetric 2% inflation target range and, to boost its credibility, delivers another rate cut. Under an easing bias, core PCE could near 2.5% YoY and headline CPI 4% by election time. Consequently, investors could finally take note of the central bank’s resolve to sustainably reignite inflation.

Investment Implications

The investment implications triggered by this grey swan depend in part on the economic backdrop. If economic growth remains robust and corporations get some pricing flexibility, equities could hold their value. Conversely, if inflation picks up against a backdrop of slowing growth, fears of a return to the 1970s’ stagflation scenario would weigh heavily on equities. Further, in our view, Treasury Inflation-Protected Securities (TIPS) and the energy and metals/mining space may prove to be more effective hedging tools than longer-dated bonds as the inflation scenario is deemed to be unexpected.

Technology Gets De-FAANGed

Technology mega caps, including Facebook, Apple, Amazon, Netflix and Google (FAANG), are enjoying an unprecedented market run. As they continue to push the boundaries of market power, we believe the potential for major US regulatory action becomes more likely, if not in 2020, then in the relatively near future.

Three major issues are placing technology firms in regulatory crosshairs. Antitrust is clearly the first as exemplified by European regulatory action against Google and resultant large fines. Second is taxation, as countries target the technology giants for new taxes because of the disparity between their prominent role in consumers’ lives and minimal local tax obligations. Third is the issue of the ownership of digital assets and privacy, as evidenced by the Facebook-Cambridge Analytica affair, which drew regulatory attention to the acquisition, use and commercialization of personal user data. Interest from regulators has increasingly called leaders of the technology giants to Washington DC.

The likelihood of antitrust action depends in part on how the regulators describe a monopoly. Antitrust regulation which broke up the early-twentieth century monopolies (such as Standard Oil in 1911) was founded on market structure – that is, the domination of a company within the business ecosystem. The concentration of power mattered more than consumer satisfaction in the early days of antitrust regulation. In the 1980s, the description of a monopoly substantially shifted from market dominance to consumer wellbeing. US antitrust regulators began evaluating consumer pricing, satisfaction and overall welfare to assess monopoly power. Consumer wellbeing has been the lens used for antitrust action for the last 40 years.

The regulatory attitude may be reversing to address the growing dominance of the technology mega firms. Although consumers may enjoy the services, the economic power of these firms is undeniable. The US Department of Justice uses the Herfindahl-Hirschman Index to measure market concentration, using 25 as a baseline for action. Internet retailing carries a Herfindahl-Hirschman Index value of more than twice that number (53), reflecting the handful of companies selling products online and running much of the cloud computing environment. Interactive media and services (Herfindahl-Hirschman Index value of 46) may also be vulnerable to regulatory action.

Investment Implications

We do not see risks of a new regulatory environment being priced into today’s market valuations. Historically, valuations have declined once a regulator acts based on expectations of lower profit margins and/or restricted growth following a resolution. Technology stocks tumbling would be a negative event for equities overall in the very short run as investors reset their growth expectations especially given the fact that FAANG stocks alone have accounted for more than one quarter of the 190% in cumulative return of the S&P 500 Index since 2012.

Investors may underweight FAANG stocks while revising their expected returns from these stocks. Also, in this scenario, rotating toward value stocks in the US since the FAANGs have significantly contributed to the outperformance of growth stocks; looking for companies enhancing productivity through technology; and buying developed market international equities (where valuations are already low on a relative basis) may prove to be useful strategies in our view.

Cryptocurrencies Come of Age

We are nearing a seminal moment in financial history with far-reaching consequences: the implementation of a state-backed digital currency. Digital currencies such as Bitcoin (whose value wildly fluctuates) have already given rise to prototype private sector stablecoins (where value is linked to sovereign currencies). Stablecoins would use blockchain technology to seamlessly and securely make payments. The private entity would redeem the stablecoin for conventional fiat currency at an established exchange rate.

The logical extension of stablecoins would be central bank digital currencies. In fact, according to the Bank for International Settlements, research into digital currency is underway at many global central banks. For example, the People’s Bank of China has indicated that it plans to launch its digital currency.

The introduction of a legitimate digital currency could be highly disruptive to the global payments system. It holds the potential to have an impact on conventional safe-haven currencies and shift global asset flows, the direction of which (positive or negative) depends on the country issuing the digital fiat currency. The US is less likely to create a digital dollar due to the enormous operational undertaking required and its cultural sensitivity to privacy. Addressing privacy issues is one current obstacle to the formation of a legitimate digital currency.

China has incentives to create a digital yuan to enhance visibility into trade and capital flows and to become a more dominant player in global finance. Admittedly, global investors may not initially embrace a digital yuan, but the practical benefits of embracing one could act in favor of such a currency. In particular, in trade finance, a digital yuan could displace the US dollar and other currencies as traders embrace the lower transaction costs and a simplified payment system. Acceptance would likely start in the Asia-Pacific region, especially among China’s regional trading partners.

Investment Implications