Political upheaval in the UK, more Covid deaths than in 2020, and escalating tension on the Korean peninsula. Just some of the events that could happen in 2021 and have an impact on investment markets.
I’ve received a briefing note today from Legal & General Investment Management’s Asset Allocation team, with a list of some grey swans to consider next year.
What’s a Grey Swan? Well, this builds on Nassim Taleb’s notion of a ‘black swan; an extremely unpredictable event where what happens is beyond normal expectations of a situation and has potentially severe consequences.
Grey swans then should be conceivably possible if not necessarily probable. A grey swan is usually a geopolitical or macro-financial event, but more to the left-field of what normally happens.
And it’s an interesting list from LGIM; lots of food for thought as we rapidly approach the end of the year, and start thinking ahead to what might be different in 2021.
I should start with a couple of important disclaimers. Firstly, these Grey Swans represent solely the investment views of LGIM’s Asset Allocation team. Don’t go doing anything silly as a result of this video. As always, it’s for informational purposes only, this is NOT advice.
Secondly, predictions should always be taken with a pinch of salt. Nobody has a crystal ball when it comes to the investment markets. Trying to time the markets is a mug’s game; if your investment strategy relies on luck, don’t expect it to go particularly well.
The best investors think about the long-term; not what happens to markets on a daily, weekly, monthly or even yearly basis, but what happens over the course of decades. While it’s great to think about what might happen in the short-term – and a one year time horizon is most definitely a short-term – these sorts of predictions, which might or might not materialise, should not form the basis of your investment strategy.
With those important disclaimers out of the way, let’s take a look together what LGIM’s Asset Allocation team came up with in this briefing.
They start by talking about their predictions last year. And I love their candid approach to this. Because, like all people who made predictions at the end of 2019, some came true and some were way off.
This time last year, LGIM identified top risks for 2020 as Argentina’s default, the Democrats winning the US presidential election, and Hong Kong losing its special status with the US. All good so far, and they do note that, with the exception of Hong Kong’s political turmoil, the impact of financial assets has been limited.
They also gave credence to the idea that the UK would leave the EU with either no trade deal or a very basic trade deal. As I record this on Tuesday evening, yeah, that looks pretty spot on as well. We’re still haggling over a reduction in fishing rights, among some other factors. There is a bit more progress being made, but it’s slow, and the clock is ticking. On the plus side, UK and EU negotiators have agreed to continue talking past the 1st January transition deadline.
Also high on LGIM’s list for 2020 was the possibility of so-called helicopter money as an extreme fiscal stimulus measure. We’ve not seen actual helicopter money in the UK, yet, but many of the government’s financial support measures look a lot look helicopter money. Furlough, anyone?
What about the pandemic then, the BIG ONE for 2020? LGIM had this on their long-list. After all, pandemics are often flagged in tail-risk prediction exercises. They also spotted the risk to markets from the pandemic quite early in the year, taking out risk-management positions in January and into February to protect against possible impacts of the virus as it started to spread beyond China.
But they admit to having underestimated the depth of impact it would have on society and the markets by the end of March, as many investors did. They say, with the benefit of hindsight, their actions were too little and too early.
The note says: “The events of the first quarter challenged our previous philosophy: that constant and expensive tail-risk hedging is not a viable solution for portfolios. That view has now become more nuanced. While we still believe tail-risk management should be targeted to the real, or outsized, risks faced by any portfolio or client, we have evolved our commitment to researching such strategies with a lower cost of carry, or performance drag. We believe that some collection of these positions can become more structural in nature even if the components, or underlying trades, are more dynamically managed.”
Another admission in this briefing if that they remained cautious on the markets, economy and virus for too long over the summer, an opportunity missed in what turned out to be a very strong second half of the year.
So that’s the past, what about the future? LGIM turn their attention to the new strain of Covid-19, already running rampant in London and the South East of England, prompting more restrictive measures. And they say the virus is likely to dominate the headlines for many months to come.
But they are optimistic about the rollout of vaccines, allowing for a broad reopening of the economy, reasonably soon. They see some tail-risk this to optimism, despite it being a sensible base case. It’s not inconceivable that the total number of deaths attributed to Covid-19 will be higher in 2021 than it was for 2020. These deaths could come predominately from emerging markets, where vaccine rollout is likely to be slower.
They also don’t rule out a third national lockdown in the UK, especially if vaccine distribution cannot meet optimistic targets. I think we’re pretty much on track for a third national lockdown; we’ve effectively got one already in large parts of London and the South East, as well as for the whole of Wales. There are lots of indications now that secondary schools won’t be returning at the start of January, with early mass testing plans for pupils looking impossible to deliver.
In terms of UK politics, this looks set for more potential upheaval. According to betting markets, there’s a 35% chance that Boris won’t still be Prime Minister in the next year. And there’s a reasonable prospect of another Scottish independence referendum.
Also in the political spectrum, our relationship with the EU will draw headlines. LGIM think that UK assets remain sensitive to these developments, but they see more upside potential than downside risk, and therefore take tactically positive view on the Pound.
Outside of the UK, US-China relations are still the main geopolitical dynamic that will shape the next decade, not just 2021. They think this subject will come back into focus for investors, once the pandemic has passed. But the path to escalation or even physical confrontation should not be ruled out.
Another tail-risk in the Asia Pacific region is the possibility of escalating tension escalating tension on the Korean peninsula, but reunification talks are also a possibility.
Some seriously interesting thoughts here from LGIM. They finish by sharing 10 more grey swans to consider for 2021, starting with the Hong Kong dollar breaking its peg against the US dollar, first established in 1983.
We heard earlier in the year that Donald Trump’s top advisors were considering proposals to strike against the Hong Kong dollar peg. But analysts concluded that the US was essentially almost toothless in hurting the peg. Banning Hong Kong from buying US dollars would be a “nuclear option” doing significant damage to global financial markets, including those in the US. If it happened, it would be a huge move, but it’s a bit like the US pressing the self-destruct button. And a transition from the Trump to the Biden administration could cool tensions with China. We’ll see!
Number two is that a central bank-sponsored crypto currency goes mainstream, cratering bitcoin. Yes, I can absolutely see this happening and Bitcoin fan bois are going to hate me for saying it. We know that central banks have their own crypto currencies in development. Assuming they meet a decent standard of security, they could blow the likes of Bitcoin out of the water. Let me know in the comments below what you think of this one.
Grey swan number three is that various new medicines or vaccines are developed for existing illnesses as a result of COVID-19 research. These could include a possible cure for the common cold and significant improvement in the fight against cancer. That would be a surprising outcome from this pandemic, wouldn’t it! What is the consequence of Covid is that we actual improve our life expectancy? Would that make the economic and social damage all worth it?
I like this Grey Swan, because the way the Pfizer/BioNTech vaccine, and a few others, have been developed using messenger RNA technology is incredible. And the speed at which it was developed is incredible too. Let’s keep in mind that any delay in rolling out the vaccine was down to safety testing and regulatory approval, not the creation of the vaccine itself; that was done many, many months ago.
We’ve got 2021 as the warmest year on record. Unfortunately not really be a grey swan as the last five years have been the warmest five on record. I’ve been out for a walk by the river today wearing shorts, it was mild, it’s late December. Climate change is here already, and it’s here to stay.
Which leads us into Grey Swan number five; “extreme weather events lead to poor harvests, shortages and food-price inflation. High food inflation feed social unrests in various countries, spooking markets and upsetting the consensus trade of long emerging-market equities.” I can get on board with this one too, and an interesting long-term investment theme to consider is sustainable food development.
Grey Swan number six; Brazil or Turkey default on their foreign bonds. Brazil’s Long-Term Foreign Currency Issuer Default Rating from Fitch is currently at ‘BB-‘ with a Negative Outlook. According to Fitch, Brazil has high and rising government indebtedness, a rigid fiscal structure, weak economic growth potential and a difficult political landscape that hampers timely progress on fiscal and economic reforms.
Turkey is in pretty poor shape too. In August, Fitch Ratings revised the Outlook on Turkey’s Long-Term Issuer Default Ratings to Negative from Stable and affirmed them at ‘BB-‘. Fitch commented at the time: “Political pressures, the limited independence of the Central Bank of the Republic of Turkey, and a track record of being slow to respond to events, increase the risk that policy is tightened insufficiently, contributing to further external imbalances, market instability, and a more disorderly adjustment. “
Grey Swan number seven; Putin retires, creating a buying opportunity for the Russian ruble. I don’t have much to say about this, but I suspect the world would become a better place once Putin retires.
Number eight, Autonomous driving finally hits the big time, with a broad introduction in a major city. I’m fully on board with this one. An interesting consequence of widespread adoption of autonomous vehicles is what it could do to house prices. I think it could flatten out house prices across the UK, reducing prices in London and other cities, and increasing prices in more attractive parts of the country. If you can jump in your autonomous car in the morning and have it drive you to work, while you get a bit more sleep or do some work, why would pay a premium to live in the City?
Grey Swan number nine, Long-lasting broad social unrest in the US in major cities, causing a correction in the S&P and US bond yields to fall below zero. US society still seems to carry a lot of tensions after the summer, and following the still disputed, at least on the part of some Trump supporters, US presidential elections. These people have got a lot of guns.
And then grey swan number ten, The Pope announces the Catholic church will allow married and female priests in their clergy. I’ve no idea what impact, if any, that would have on global financial markets. If you know, let me know in the comments.
But thank you to LGIM’s Asset Allocation Team for that briefing. I get a lot of these passed across my desk; would you find it useful to hear about more of them along with my take on what they could mean? I’m happy to create more videos like this in the future.