Grey Swan Events: Tail Risks in 2023
Dec 29, 2022
In his book, The Black Swan: The Impact of the Highly Improbable, Nassim Taleb defined the explored unpredictable financial events with extreme consequences – in other words, a “black swan.” Accordingly, by identifying potential risks to financial markets in 2023 ahead of time, these events can no longer be considered “black swans.” Rather, we call these tail risk events “grey swans”: low probability, known events that, were they to occur, would yield sweeping consequences for markets.
One of the consequences stemming from China’s zero-COVID policy in 2022 was a spat of civil protests unseen since 1989. In response, over the ensuing weeks, the Chinese government announced a relaxation of lockdown restrictions and quarantine measures while similarly offering up fiscal support for a relatively lackluster economy.
Given that the Chinese government’s main prerogative is to retain absolute control, civil unrest - and yielding to it - threatens its moorings to power. Should COVID-19 infections skyrocket in early-2023, prompting a return to lockdown restrictions and quarantine measures, it’s possible that another wave of protests emerges.
In response, in order to turn the Chinese population’s focus away from domestic strife, the Chinese government could turn its attention back to Taiwan, which was the focal point of escalated geopolitical tensions for much of 2022. Ultimately, an invasion of Taiwan could be instigated in order to shore up domestic support within China.
What to Watch: FXI, KWEB, SMH, /6A, BABA, JD, LMT, RTX
The onset of the Russian invasion of Ukraine produced a dramatic spike in commodity prices for two main reasons. First, one of the world’s prominent grain producers, Ukraine, was suddenly unable to meet supply expectations as sowing season was upended and distribution by rail and sea was disrupted. Second, Russia threatened to cut oil production should the West retaliate, which they ultimately did with aggressive sanctions, culminating in an oil price cap in late-2022.
While commodities like crude oil, natural gas, and wheat have since climbed down from multi-year - and in some cases, multi-decade - highs, the fact of the matter is that Russia’s invasion of Ukraine is still ongoing. Even though there has been some chatter lately about a new round of negotiations to end the war, perhaps by February 2023, the risk persists that the war enters a new phase of attrition. The result would be sustained volatility in energy and soft agricultural commodities throughout 2023.
What to Watch: /CL, /NG, /ZW, USO, UNG, CVX, XOM, OXY
One of the knock-on effects - or perhaps, directly intended effects - of the Federal Reserve’s rate hike cycle has been a sharp rise in US Treasury yields, which have spilled over into mortgage rates. But it’s not just the Fed: the Bank of Canada, Bank of England, European Central Bank, among others, have all raised rates rapidly in recent months in order to combat inflation pressures, pushing up mortgage rates around the Western world.
This development has reduced housing affordability in the United States, no doubt. But American homeowners typically have fixed-rate mortgages; less than 10% of US mortgages are variable-rate. It presents a different problem in countries like Australia, Canada, and the UK, where variable-rate mortgages are the norm, constituting a significant share of debt held by homeowners (Canada: approximately 35% of mortgages are variable-rate; in the UK, over 95% of mortgages are variable-rate).
A continuation of rate hikes by central banks in 2023 could precipitate housing crises across Western economies, leading to a prolonged period of weak (if not negative) economic conditions.
What to Watch: XHB, TLT, /ZN, /ZB, /6A, /6B, /6C, LEN, TOL, PHM
The European Union’s and United States’ response to Russia’s invasion of Ukraine was to try to ringfence the Russian economy by cutting it off from global payments and transfers systems. This was done by limiting access to SWIFT - a messaging channel between financial institutions - and CHIPS - an international payments channel. There are over 11,000 financial institutions across 200 countries that use SWIFT, and 43 private institutions that use CHIPS. The bedrock of these systems is the fact that 40% of all international claims are settled in US Dollars and over 35% are settled in Euros.
Seeing how the EU and the US cut Russia off from large swaths of the global financial system with relative ease, it may be the case that developing countries on more neutral geopolitical terms seek to find alternative means of payments and transfers, lest they stay beholden to the whims of the West. In the very near-term, it’s unlikely that China (with CIPS) and Russia (with SFPS) can dislodge the US Dollar hegemony, but they will continue to lay the groundwork for an alternative means of commerce where they can. This may also mean central banks seek to diversify their foreign exchange reserves away from Euros and US Dollars over the coming years.
What to Watch: UUP, /6E, KWEB, FXI, ERUS, XLF, /GC, /SI
After the Global Financial Crisis, central banks in Europe and North America flooded the financial system with cheap money in order to stabilize banking systems and promote economic growth. As the saying goes, “water finds its own level,” so too does excessive liquidity, reaching into every crevice of the global economy. Soon after the Global Financial Crisis, soaring soft agricultural commodities pushed up food inflation rates across the developing world, leading to a period of political and societal unrest in the Middle East and North Africa known as ‘The Arab Spring.’
2022 already produced a surge in food prices globally, with many currencies in emerging markets depreciating rapidly over the course of the year. Consistent with Grey Swan #2, “Ukraine War Intensifies; Food & Energy Inflation Return,” if 2023 sees similar escalated geopolitical tensions, then the risk of an Arab Spring 2.0 will only increase. As was the case in the early-2010s, this would mean even more volatility in commodity prices, coupled with the risk of destabilization across many economies in the developing world - Brazil, Egypt, Turkey, and South Africa, to name a few.
What to Watch: /CL, /ZW, EWZ, EEM, EZA, EGPT, TUR, /GC, /SI
— Written by Christopher Vecchio, CFA, Head of Futures & Forex
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