Grey Swans: The gathering storm


1 Feb 2024

At a time of heightened geopolitical risk, Andrew Holt asks if investors should prepare for rare but damaging market events?


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At a time of heightened geopolitical risk, Andrew Holt asks if investors should prepare for rare but damaging market events?

Grey is the new black. Since former options trader turned professor Nassim Nicholas Taleb published a book on black swans in 2007, investors have been on their guard against events that have a severe impact on the markets and are said to be difficult to predict.

But there is now another swan on the block to colour the outlook of events: grey swans.

The precise definition of a grey swan has been debated – making it grey in more ways than one. But generally, they are high impact events that have little chance of occurring.

“A grey swan is a low probability event, yet one that carries risk with potentially broad investment implications, albeit not necessarily all negative,” says Lori Heinel, global chief investment officer at State Street.

A slight variation is offered by Catherine Doyle, investment specialist at Newton Investment Management. “Grey swans are possible, but unknown events, which slightly shifts the emphasis,” she says. It is a difference in nuance, but still points to events that investors should be trying to identify and do something to address the risk they create.

Richard Tomlinson, LPPI’s chief investment officer, offers his own take on a grey swan in percentage terms. “It’s not close to zero probability, more like a one in 20 event,” he says.

Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management, weighs in with his own interpretation. “Grey swans should be conceivably possible, if not necessarily probable,” he says. “They typically fall into the camps of geopolitics or macro financial markets but can be more left field.”

Risk aware

Grey swans do not exist in a philosophical vacuum. Heinel notes that thinking about them can help investors consider alternative scenarios. “It is something of a given, but the future is always uncertain,” she says, yet adds that thinking about scenarios which diverge from a “base case” helps inform the “risk-aware approaches investors can apply across their portfolios”.

Heiligenberg also highlights why grey swans are relevant to investors. “Market pricing reflects the probability weighted average of different scenarios, including tail risks.

Investors often have a base case but should prepare for multiple scenarios,” he says. And the challenge for investors is that grey swans can come in multiple forms.

LGIM’s mantra, therefore, Heiligenberg adds, is an interesting perspective on the multiple scenario perspective: ‘prepare, don’t predict’.
 “Thinking about grey swans is all about considering what is possible, even though it isn’t probable,” he says.

“This helps us to identify signposts, to anticipate a scenario sooner or better than most or consider hedges, for outcomes that are particularly detrimental for investors.”

Doyle agrees, that, as a thematic house exploring investment themes and how they play out is a given for Newton. “We talk all the time about the risks and opportunities in markets,” she says. “We are always identifying opportunities and risk, with grey swans coming under the risk category. But we are always looking at both sides: the opportunities and risks.”

In the context of portfolio management, Doyle says that it is around translating into how your portfolio is positioned to deal with such events. “It may translate into avoiding a particular asset class,” she says.

“The reality is that there are a whole range of events that we are already aware of like some of the wars bubbling away at the moment, which are risks, and could morph into something more worrying,” Doyle adds.

The challenge for investors is that grey swans can come in multiple forms.

Emiel van den Heiligenberg,
 Legal & General Investment Management

Different horizons

Tomlinson’s fund is looking at potential grey swan scenarios in two ways currently. “We are looking at the geopolitical situation – as near horizon scenarios – and climate and related challenges at longer-term horizons,” he says. “My feeling is the timeline for grey swan risks in the climate nexus is over a five to 10 year horizon.”

The shorter-term horizon grey swan assessment is focused on topics familiar with the current environment. “These are around the geopolitics, the escalation of war in the Middle East, oil prices and inflation, with the latter possibly getting a nudge upwards in the grey swan scenario.”

Heinel says that geopolitics is a central point of focus when thinking about grey swans. “With escalating geopolitical tensions, major elections and monetary policy reaching a critical   juncture, the year ahead will be challenging for investors. 2024 will require agility to respond to market signals and multiple factors within the macro-economic environment,” she says.

She therefore points to “pockets of opportunity can be found in equities,” but considers fixed income offering better opportunities “given current rates and our expected path of growth and future rates”.

On this level, fixed income is one of the best-positioned asset classes from a risk/reward standpoint – in particular sovereign fixed income – US treasuries specifically – may be an attractive proposition, especially over the medium term.

Election time

Digging deeper, where do we search for specific grey swans? One good place is the not so small matter of politics. This is a big election year across the globe. Indeed, most of the world’s population – more than four billion people – will be stepping inside a poll booth at different times throughout the year.

There are though three election grey swans hidden in plain sight. In the UK there is going to be an election, with the expectation that Rishi Sunak will announce it will take place in the Autumn.

There is a problem here which leads to the first potential election grey swan. Sunak will have to survive the expected severe fallout from local elections, which will take place on 2 May. Within this scenario it is possible that the results are so awful that he is forced out by unhappy Tory MPs.

It would be a case of deja vu all over again for the Conservative Party. This could result in complete turmoil – would a new leader have a mandate to lead? Would an election be forced? And what would the impact be on the markets?

A worst case market scenario could see the turmoil unleashed by Liz Truss’ premiership seem like a quiet weekend in the City. Meaning in short – investors would be best to avoid UK stocks and bonds. Such a move could escalate a deteriorating market situation.

“What would happen to sterling?” asks Tomlinson, when dis- cussing such a grey swan scenario. “Gilts could struggle, or yields spike materially again,” he adds.

But Doyle is not sure it would come to that, although she wouldn’t rule it out. “There is, however, an awareness among Conservatives to provide stability as the population has been subjected to a lot of change and they in fact want to portray stability,” Doyle says.

Tomlinson adds another scenario to the mix. “The Labour Party also faces challenges, given the questions Keir Starmer faces on the Hamas-Israel situation and he was at the CPS when the Post Office prosecutions were going on.”

This grey swan could leave both main parties in potential paralysis, which would leave the country and markets in a parlous state.

Yes, Mr President?

And who could possibly forget that it is election year in the US. Here, the grey swan scenario is that Biden and Trump don’t make it to the final contest. With the big risk scenario that the courts stop Trump from running.

This is already playing out in Colorado and Maine, but the picture could get complex depending how the Democrats play it throughout 2024. The central point is American democracy could well come under considerable pressure, and with it a market upheaval.

In addition, there could be close results in swing states leaving the whole election in a state of limbo: with a scenario that sees lawyers and judges going as far as picking the next president. Neither candidate making it on the ballot would have serious repercussions.

“You probably will see a lot of social unrest,” Doyle says. “You could even see an independent candidate coming in – but that would make it more of a black swan,” she adds.

Tomlinson also says the scenario is a worry. “It is the idea of America being at war with itself which is concerning on so many levels.” For him, the election nightmare scenario leads back to deep geopolitical repercussions.

“The issue would have international implications, because I suspect the US would trundle through, but it may encourage other actors to pitch themselves internationally, maybe Iran, because the US could be perceived as weakened,” he says.

We live in a world of
 not just black swans but multitudes of grey swans and you need flexibility to shift focus and repurpose the portfolio if facts change.

Catherine Doyle, Newton Investment Management

Great tensions

Doyle also puts forward an interesting grey swan. “Although in the UK we talk about Trump winning the election, in the US they are not giving much credence to it,” she says.

Her central point as a grey swan is that Trump’s election victory would have implications for geopolitical tensions, but also creates investment opportunities. “It is hard to predict exactly how that would play out, but we know Trump has certain leanings towards US manufacturing, which would give this sector a boost from an investor perspective.”

Doyle says this can be developed as a convincing grey swan especially when you consider Trump’s first term and the playbook he followed. Although she adds: “There would be other investments that would become vulnerable, such those in Mexico, as the border issue would be a big point of focus making Mexico investments vulnerable.”

Lastly on the grey swan election radar is the Netherlands. This year the country will decide whether to appoint the right wing Geert Wilders as prime minister after he clearly won first place in November’s general election.

Whatever happens, if Wilders is appointed leader, or kept out by the political establishment, it is likely to have wider implication throughout Europe’s markets.

Some investors have noted that this would create a lot of instability in Europe. “It would play out as a nightmare for the EU. It could feel like EU fragmentation,” says one investor. “It would increase the risk premium for Europe. We could have spreads widening in bonds,” the investor adds.

Tomlinson finds this interesting. “There is a bigger theme here that we need to keep an eye on: the development of reductionist thinking, the ‘if you are not with us, you are against us’ line. This is likely to have further implications for other grey swans.”

It is the idea of America being at war with itself which is concerning on so many levels.

Richard Tomlinson, LPPI

Conflict everywhere

But for many grey swan scenarios it is likely to come back to one issue: the escalation of geopolitical conflict, which present a key risk for investors. In 2024, the shifting geopolitical landscape – from uncertainty around international and trade relations, conflicts and, as noted, the ability of upcoming elections to reshape the outlook – all deserve close monitoring and agility in portfolio positioning.

“For 2024 – unfortunately, but inevitably – a significant number of grey swans are in the geopolitical arena,” Heiligenberg says.

On this level, and probably top of the list, is the possibility of greater escalation in the Middle East with Iran entering the Israel-Hamas war.
 “That would increase the political-risk premium of the oil price,” Doyle says. “Geopolitical shocks are mostly felt by commodities, and the oil price in this instance. So having exposure to traditional energy stocks would mean exiting those in this scenario.”

Within the grey swan geopolitical arena at some point China has to come into full focus. Expanding on this, Doyle does not let us down, highlighting China blockading Taiwan as a grey swan scenario.

“This would lead to supply-chain issues, particularly for semi-conductors. That would be negative for tech,” she says.
 “It would not happen overnight, but it will catch-up with port- folio managers. The magnificent seven stocks have been dominating market returns, but if you get this grey swan event investors will have to re-think the type of tech exposure they have.”

Another grey swan involving China is something of a reversal of the current muted investor approach to China.
 “If we were to see China recover strongly – which is not priced into markets, as everyone is still bearish – it could be categorised as a grey swan, because investors don’t think it is going to happen,” Doyle says.

The point being that investors seem to have written off China. “But the domestic data is improving,” Doyle says. “We are seeing a pickup across Asian trade. So it is not inconceivable that we see a strong recovery in China.”

So how should investors approach this grey swan? “There are plenty of ways you can play China, by playing into China demand that would be an opportunity by increasing investor positions in areas such as commodities and industrials,” Doyle says.

The inflation swan

Then there is the more standard economic outlook. Inevitably, the inflation scenario rears its head. Doyle says one grey swan could be that inflation does not prove transitory. “At the moment you have markets discounting the Goldilocks scenario and that inflation will go back in its box,” she says.

But if inflation spikes that would be something of a shock to the market. “That is not being priced in,” Doyle says. “It would therefore necessitate a portfolio with some in-built hedges, in terms of holding real assets and some alternatives linked to inflation. So you can insulate the portfolio to some extent.” But what of those portfolios that lack these?

“Well, it would be a case of emphasising certain parts of the portfolio. We have a bias towards equities and the pricing power enables to pass through the costs,” Doyle says.

“So we might look to increase our equities, shy away from holding bonds, as an inflationary environment is not good for bonds, and increase alternatives, especially the inflation linked ones. We would also, potentially up the gold exposure, as an inflation hedge,” she adds.

Heiligenberg also has an interesting grey swan insight on the macro financial picture.
“In a higher rate environment, there’s the possibility of a large leveraged player – such as a bank, insurer, hedge fund or corporation – getting into trouble, triggering a flight to quality,” he says.

“These events may not be our base case scenario, but it’s important as investors that we consider the full range of possibilities and prepare accordingly.”

Deficit debacle

In the US economic context, there is a potential grey swan where pressure is brought to bear on the US de cit. “There is a lot of talk of a dry up in treasury-backed products and this could have unintended consequences on the bond market,” Doyle says. “Bonds are, after all, the plumbing of global markets.”

One of the biggest issues being addressed and discussed in financial markets is that of artificial intelligence (AI). Investment researcher Macro Hive has come up with an interesting grey swan on this much-debated topic.

Macro Hive’s Karl Massey places a grey swan at the heart of the investment world, as it is shocked by an expose that an AI model has been manipulating global financial markets for the past six months.

Possibly a little more sci-fi than grey swan, this could trigger chaos among investors, leading to a collapse in equities, commodities, high-yield bonds, real estate and currencies.

Regulators would then step in suspending the affected markets, creating its own potential chaos in the process. Whether this is likely, is a moot point, but the issue that AI may be a grey swan hidden in plain sight is surely a valid one.

Offering a lighter note on grey swans this year, Heiligenberg says: “I am Dutch, so it would be remiss of me not to mention a grey swan for 2024: for the Netherlands to win the Euros this year.” Now which investors are willing to embrace the risk connected to taking a punt on that?

Addressing grey swans

Tomlinson in turn has advice on how investors can deal with the precarious nature of grey swans. “To address grey swans you try to build a portfolio that performs in expected central cases survives a broad range of stresses and downside scenarios,” he says. “To do that you bring together the probable scenarios and then assess: what if that happens, and how you should deal with it.”

All of these scenarios point to one thing, Doyle believes. “That is to have flexibility and a nimble investment approach which is fundamental for the years ahead,” she says. “We live in a world of not just black swans but multitudes of grey swans and you need flexibility to shift focus and repurpose the portfolio if facts change.”

To extend this further, and to use a boxing analogy, in dealing with grey swans effectively, investors need to learn an Ali shuffle. They can then box out of a tricky situation when they are well and truly on the ropes.


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