A ‘grey swan’ is a by-product of Nassim Taleb’s ‘black swan’. Taleb described a black swan as an extremely unpredictable event where what happens is beyond normal expectations of a situation and has potentially severe consequences. Grey swans should be conceivably possible if not necessarily probable. They typically fall into the camps of geopolitics or macro financial markets but can appear more left-field. This year, we are naturally more attuned to potential COVID-19 outcomes, as well as environmental, social and governance (ESG) -related matters. It’s also a good time to look back at what we said this time last year and consider what impacts those events had on markets, if they materialised.
What did we get right and wrong in 2020 – and what had an impact?
Let’s start with the small stuff before we move onto the elephant in the room. Among our top risks for 2020 that came true were: Argentina’s default; the Democrats winning the US election; and Hong Kong losing its special status with the US. Of these, despite the deep social impacts of Hong Kong’s political turmoil, the impact on financial assets has been more limited.
We gave credence to idea the UK would leave the EU with either no deal or a very basic deal, something that now seems almost certain. Also high on our list for 2020 was the possibility of ‘helicopter money’, but for all the fiscal stimulus measures of the past year, purists would still say we have not seen the choppers in the sky – although for us this seems like semantics.
Obviously the big risk event of the year was the pandemic. Pandemics are often flagged in tail-risk prediction exercises and were indeed included somewhere in our long list of risks for 2020. If we are generous to ourselves, we even recognised the reality of the risk 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, just like many investors, we underestimated the depth of impact it would have on society and on markets by the end of March.
In hindsight, our actions were too little and too early. 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.
Finally we 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 for our clients.
2020 is a hard act to follow. What could put 2021 in the record books?
As exemplified by this weekend’s news in the UK, with a new strain of COVID-19 identified and much of the South-East placed under more restrictive measures, the virus will likely dominate the headlines for the months ahead.
However, there is optimism that the roll-out of vaccines will allow a broad reopening reasonably soon. While such a narrative is a sensible base case, and indeed we have exposure to asset classes that will benefit from this, we see tail risks to the optimism.
First, it is sadly not inconceivable that the total number of deaths attributed to coronavirus will be higher in 2021 than for 2020. The social toll will continue to be heavy, and these deaths may come predominantly from emerging markets, where vaccine rollouts look to be slower and countries are experiencing new accelerations in case numbers. A third national lockdown in the UK cannot be ruled out, especially if vaccine distribution cannot meet optimistic targets.
UK politics looks set for more potential upheaval; betting markets attribute roughly a 35% chance of Boris Johnson ceasing to be prime minister in the next year, while a Scottish independence referendum remains conceivable. And that’s not to mention the state of the relationship with the EU, which could stay in the headlines through 2021. UK assets remain sensitive to these developments, but from here we are tactically positioned with a positive view on the pound as we see more upside potential than downside risk.
Beyond our borders, US-China relations remain the predominant geopolitical dynamic that will shape the next decade. When the virus has passed, we believe this topic will come back into focus for investors. Most of our team believe the relationship will either stay the same or mellow, but the path to escalation and even physical combat should not be discounted. Also in the Pacific area, our tail-risk scanning exercises again drew our attention to the possibilities of escalating tension on the Korean peninsula but also suggest that reunification talks accelerating are equally likely.
Ten more grey swans for 2021 to consider:
- The Hong Kong dollar breaks its peg against the US dollar, first established in 1983
- A central bank-sponsored cryptocurrency goes mainstream, cratering bitcoin
- Various new medicines or vaccines are developed for existing illnesses as a result of COVID-19 research, including a possible cure for the common cold and significant improvement in the fight against cancer, leading to the view, with hindsight, that the COVID period has actually improved our life expectancy
- 2021 is the warmest year on record. This unfortunately wouldn’t really be a grey swan as the last five years have been the warmest five on record
- 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
- Brazil or Turkey default on their foreign bonds
- Putin retires, creating a buying opportunity for the Russian ruble
- Autonomous driving finally hits the big time, with a broad introduction in a major city
- 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
- The Pope announces the Catholic church will allow married and female priests in their clergy
…and perhaps one black swan: England win the Euros on a penalty shoot out
Wishing everyone happy holidays,