- Nomura Global Research
In the financial markets, black swans happen. It is, by definition, an unpredictable or unforeseen event that comes with extreme consequences – but its “close cousin, the gray swan, can be envisaged,” according to Nomura Global Research.
The gray swans are “unlikely but impactful events” that “lie outside the usual base case and risk scenarios of the analyst community.”
The team at Nomura has come up with 10 potential gray swan events for 2017, forgoing more widely discussed scenarios to focus on the more under-the-radar topics.
“Needless to say, none of the them are our base case,” the FX strategy team wrote in the report. “But we think it is better to be prepared than not.”
Shock 1: ‘US productivity boom’
- Nomura, Bloomberg
Global productivity has been lacking since the 2008 financial crisis, and in 2016, US productivity growth has “seemed to grind to a halt.” This compares with an average of over 2% productivity growth since World War II, initially declining from the dot-com collapse and then sustained by the crisis.
Looking at the past 10 years of data, it would be reasonable to expect productivity to range from -0.2% to 2.6%, according to global FX strategist Bilal Hazeez. But, Hazeez asks, what if we are wrong? From a purely statistical perspective, “productivity is a volatile data set.”
Historically, investment has been a key contributor to poor productivity. Conventional investment in buildings and equipment is at recessionary levels, but digital investment in intellectual property and R&D is running at close to postcrisis highs and could provide the foundation for a surge in productivity, he writes.
If this were to happen, implications for the markets would be huge, leading to stronger equity markets and a more aggressive Federal Reserve hiking path.
Shock 2: ‘China floats currency’
- Bloomberg, CEIC, Nomura
The idea of China shifting to a floating currency in the near term is pretty low, and the current path of periodic FX flexibility combined with intervention is likely to continue over the next 12 months, according to Nomura Asia FX strategist Craig Chan.
However, China’s long-term goal is to move toward a free float, and in a gray swan event, it could happen sooner than expected, with far-reaching effects.
If China were to suddenly adopt a free-floating FX regime and no longer intervene, the team believes the renminbi would depreciate rapidly, leading to a sell-off in local markets and causing negative regional and global market contagion.
“The risk of China shifting to a free float could lead to a severe balance of payments shock with serious negative economic/financial market consequences,” Chan wrote.
Shock 3: ‘EU reforms, UK rejoins’
- Nomura, Bloomberg
2016 was the year politics “stumped the consensus” according to FX strategists Jordan Rochester and Anna Titareva, so why couldn’t 2017 do the same? With Brexit, a Trump victory, and the Italian referendum, in politics, “one cannot rule anything out.” This includes a gray swan scenario in which the EU as a whole reforms and the UK rejoins.
The team identifies two ways this could happen: a UK-led movement to unwind the Brexit decision and rally around a single market access agenda or an EU-led one, in which the EU offers the reforms the UK has been asking for all along, including redefining the free movement of labor. According to the report, this could come as the EU attempts to limit the growing anti-EU sentiment in the euro area in a year of major elections across Europe.
Shock 4: ‘Japan inflation surge’
- Nomura, Bloomberg
Japan has an inflation problem. The latest print for headline inflation was only 0.1%, and core inflation was at 0.2%. For the year ahead, consensus expects a slight pickup to 0.5%, while Nomura economists expect this to be lower, at 0.3%.
But Nomura FX strategists Andy Chaytor and Anne Karina Asbjorn ask: What if we are all wrong, and Japan instead experiences a sharp pickup in inflation?
In their opinion, the most plausible way for this to happen would be through the interplay between the dollar/yen and oil prices. Up until recently, there has been a negative correlation between the dollar and oil, so when oil prices were falling the yen was also weakening, and vice versa. This resulted in the deflationary impulse of lower oil prices being offset by the inflationary impulse of a weak yen. This correlation between oil and the dollar has started to weaken and could even flip “so that higher oil prices and a weaker yen happen concurrently.”
This has happened since Trump’s election victory. “We think this would then result in both oil and and yen providing inflationary impulses, which could provide a ‘big surprise for 2017,'” the team wrote.
Shock 5: ‘Fed muzzled’
- Win McNamee/Getty Images
President-elect Trump was outspokenly critical of the Federal Reserve and Janet Yellen throughout his campaign, arguing that interest rates should be higher and that the Fed balance sheet should be reduced. While he has tempered his tone since being elected, he could still try to change the way the Fed operates, according to Nomura economist Charles St-Arnaud.
Trump has been vocal about the potential of requiring more scrutiny in the form of an audit of Fed activity, about greater supervision from Congress, and about altering the Fed’s mandate in terms of inflation targeting that includes asset prices, such as house prices.
He also spoke about creating “Taylor rule”-based rate decisions, where policy rates are automatically adjusted to changes in the determinants of the rule – eliminating any discretion in monetary policy and making it more predictable – and a return to a gold standard or rule-based supply of money, thereby preventing bubbles and containing inflation.
With currently two vacancies on the Federal Reserve Board, Trump will be able to name board members with similar views. With Yellen and Vice Chair Stanley Fischer’s term expiring in 2018, the president decides, with Senate confirmation, who of the current sitting board members is nominated chair and vice chair.
There is also the risk that any changes in the Fed’s mandate could lead to the resignation of current members, according to St-Arnaud, allowing Trump to name more like-minded governors.
Shock 6: ‘Russia flexes its muscles’
- REUTERS/Maxim Shemetov
While Peter Attard Montalto, an emerging-markets research analyst, confirmed that it’s not Nomura’s baseline that Russia will undertake any military engagement against Eastern Europe in 2017, is it a question investors are asking, and could be a gray swan event.
There is recent precedent – in Georgia in 2008 and Ukraine in 2014. In particular, Montalto sees the plausible forms of Russian aggression to be in the Ukraine and in the Baltics, where countries are already increasing defense expenditure, undergoing training operations, and putting in place emergency procedures.
Shock 7: ‘Clearinghouses fail’
- The Trade Desk/Twitter
One major regulatory change affecting how over-the-counter derivatives are traded that has been introduced in the aftermath of the financial crisis is the role of central counterparties.
These entities act as intermediaries between counterparties in interest rate swaps and some other derivatives, and are designed to reduce counterparty risk in the system and contagion risk throughout the system when one bank fails. In essence, when two banks enter a bilateral derivative transaction, the CCP steps in and sits between the two banks, protecting each from the other’s counterparty risk.
Although this is designed to reduce systemic counterparty risk, some argue these entities have instead concentrated all the risk in one place. Although the risk of CCP failure may be small, the implications in that sort of gray swan event would be far-reaching and significantly more damaging than the default of a single bank.
Shock 8: ‘Japan’s Abe loses power’
With a general election in Japan expected in 2017, the biggest political shock would be anything that fractures the stability of the current institution, according to global FX strategist Yujiro Goto.
If the four main opposition parties nominate joint candidates, which is currently being discussed, current Prime Minister Shinzo Abe’s Liberal Democratic Party could lose its solo majority in the lower house and the supermajority. Abe’s position would be substantially weakened, and the most extreme outcome could be his resignation or a regime change to the cabinet, Goto writes.
If this gray swan event were to happen, Abenomics trades would be unwound, and Japanese equities would fall. Moreover, the dilemma for the Bank of Japan would be compounded with an Abe resignation, leading to uncertainty over Bank of Japan Governor Haruhiku Kuroda’s successor after his terms ends in 2018.
Shock 9: ‘EM capital controls return’
- REUTERS/Thomas Peter
In the “Trumpflation” world of higher US yields and a stronger dollar, emerging markets may face even more pronounced outflows than in 2016, according to Montalto and Inan Demir. If this were to happen, “we may see concerted action by EM policymakers for the first time.”
If some countries are implementing capital controls as part of a currency war strategy, it could lead to a “deflection of flows” with investors exiting the countries that they can. This would only increase the incentives for concerted action among EM policymakers.
“This may well be a theme we see play out in part, though not in full, moving through 2017,” Montalto and Demir wrote.
Shock 10: ‘Paper money disappears’
According to global FX strategist Sam Bonney, there are three main arguments for abandoning notes and coins and moving to an electronic money system: tracking criminal transactions, moving toward digital payments, and charging negative rates.
The Nomura note argues that developed countries could lead the way in a conversion to a purely electronic money system. Sweden has been discussing the prospect, and Japanese banks are coming closer to using blockchain in the payments system.
Although it would be a gray swan event, “it seems we are on the threshold when secure decentralized electronic money and payments systems could replace notes and coins in circulation,” according to the note.