IQ INSIGHTS

February 2016

Our Top 10 Gray Swans for 2016.

Lorne Johnson, Ph.D.,

Senior Portfolio Manager, Investment
Solutions Group (ISG)

As China rang in the Lunar NewYear

on February 8, global marketswere
mired in grim news. Equity indexes
were off by double-digit numbers,
largely on slumping Chinese growth
and low natural-resource prices.
Happy Year of theFire Monkey.
Itsshaping up tobe eventful.
Last year, State Street Global Advisors (SSGA) ISG Politics
andPolicy team published a list of our Top 10 Black Swans for
2015. We hedged our predictions by reminding readers that
forecasting tail risk is, by nature, a nearly impossible exercise,
undertaken only by gluttons for punishment like us. Still, 4
ofour 10 predictions came true: a further economic slowdown
in China, an overall decline in global growth, an additional
contraction in commodity pricing, and a significant terrorism
surprise. We may have been right on another point as well a
US monetary policy mistake although its too soon to say
forcertain.
With a track record like that, weve decided to try our luck again
this year, with a couple wrinkles. First, were pegging our
tail-risk predictions to the Lunar New Year, given the outsized
role China appears poised to play in downside risk this year.
Second, were changing the swans color, from black (meaning
exceptionally rare and unknown) to gray (unlikely, but possible

and potentially foreseeable). So here is our list of possible

flare-ups for 2016. Just a reminder: These are not our base-case
scenarios, and the events that (continue) to rock markets this
year may not exactly be these. But like last year, were willing to
bet that were getting warm.
1. A One-Off Chinese RMB Maxi-Devaluation China is at a
critical juncture in its economic development, with huge
implications both for its domestic economy and the rest of the
world. As the Year of the Fire Monkey began, China found
itselfsaddled with debt (more on that later), while it attempts to
shutter underperforming companies and engineer a challenging
transition from an investment-driven to a consumer-driven
economy. Meanwhile, to keep its economy competitive, the
Peoples Bank of China (PBOC) has been seeking to liberalize
the renminbi (RMB) a delicate task under the best of
conditions. So far, Chinas currency transition has been opaque
and erratic.
Beginning in August of 2015 China began modifying its
long-standing currency policy, which had managed the RMB
inreference to an undisclosed currency basket (thought to be
dollar-dominated). The modifications ultimately established
atransparent reference basket of about a dozen currencies.
Thetransition led to two small-but-unexpected depreciations
the first in August 2015, the second to ring in 2016 both of
which were quickly followed by major global equity market
corrections. The latter episode, in which China allowed its
official rate to fall a mere 0.25% more than expected, caused
theoffshore rate to gap down on anticipation of more
depreciation. With currency outflows soaring, several
high-profile hedge funds placed huge bets that the RMB
woulddropas much as 30%, setting up a public showdown
withBeijings central planners.
The PBOC has aggressively purchased the RMB and declared
that it would defend its currency. Chinas huge foreign exchange
(FX) reserves give it ammunition, but RMB purchases
contributed to a $750 billion reserve decrease in 2015 alone,
and some investors are questioning whether Chinas available
reserves are really as large as the $3.23 trillion that the PBOC
reported as of January 31, 2016. Further complicating matters,
defending the RMB tightens the money supply at a time when

IQ Insights | Our Top 10 Gray Swans for 2016.

Chinas growth has been steadily deteriorating, although the

PBOC has sought to offset this tightening by relaxing the
reserve-requirement ratio.
Then just after the Chinese New Year, the PBOC surprised the
market once again by revising the RMB currency-basket in
favor of a quasi-dollar peg. Perhaps not surprisingly, the shift
was preceded by a slide in the US dollar, allowing for a further
easing relative to its regional trading partners. As this story
evolves, it seems the only certainty is that the RMBs fate will
remain unpredictable for the foreseeable future. If Chinas
RMB conundrum forces a steep drop, markets could be in for a
very volatile ride.
2. Emerging Market Corporate Debt Crisis Since 2008 the
stock of EM hard-currency debt has grown from $600 billion to
over $1.7 trillion.1 That record level of EM debt has coincided
with a sharp slowdown last year in EM growth, impairing the
ability to service that debt.
China again is an area of specific concern. More than half of
corporate EM debt originated in China, where the corporate
credit level is 135% of GDP.2 A lot of Chinas debt-fueled
spending now appears far from optimal. Investments in
manufacturing have led to excess capacity, while an aging,
increasingly affluent population balks at factory work,
drivingup labor costs. Chinas previously booming real estate
market has slumped, leading to ghost developments with few
inhabitants. Non-performing loans rose to nearly $200 billion
as of December 2015,3 and the Chinese government continues
toopen the credit spigot, hoping to keep growth over 6.5%.4
Outside of China, both Brazil and Russia are in recession,
withfinances strained by plummeting currencies and
depressed commodity prices. External corporate debt in
Russiastands at $74 billion, and in Brazil at $95 billion.5 If
commodity prices dont appreciate, we could see default rates
rise. Complicating matters, EM central banks have allowed
their currencies to devalue as a form of back-door quantitative
easing to stimulate growth. This, however, will only further
stress holders of dollar-denominated debt. Given a slowing
economy and the risks of further currency devaluation,
EMdebt appears poised to further strain the global
financialsystem.
3. A Reversal of European Integration In 1956, a customs
union called the European Economic Community (EEC)
wasestablished among Belgium, France, Italy, Luxembourg,
theNetherlands and West Germany. Over the 60 years since
then, the EEC has evolved into the European Union (EU),
which nowincludes 28 member states with over 500 million
inhabitants. Along the way, a series of agreements tore down
numerous barriers to trade, cross-border travel and the like,
and established a European government. Nineteen EU
membersnow use a common currency an impressive
featofcooperation among diverse nations.

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In 2016, the European project is facing severe headwinds.

Theyear may end with fewer member states or new
restrictionson trade and travel. The 2015 terror attacks6 and
refugee crisis have already strained the Schengen agreement
(which allows passport-free travel across most EU countries).
Six states, including Germany and France, have imposed new
border controls to limit the flow of refugees. As tensions mount
and negotiations drag on over the fate of the million-plus
refugees who have arrived since early 2015,7 nationalistic
parties that have peddled Europhobia (and xenophobia) for
years have been gaining real traction. In December of 2015,
forexample, Frances anti-immigrant, anti-EU Front National
actually won the opening round of regional elections with
record results.8 Meanwhile, tensions are high between the EU
and the increasingly authoritarian, euro-skeptic governments
of Poland and Hungary.9
Probably the biggest risk for Europe in 2016 is a June 23 United
Kingdom vote asking citizens if they wish to remain in the EU.
Currently, the result is uncertain. After extracting concessions
from the EU, Prime Minister David Cameron will campaign for
Britain to remain in the union. Other prominent conservatives,
including Londons popular mayor Boris Johnson, are backing
an exit.10 If a Brexit did occur a big if pro-EU forces foresee
serious economic shockwaves across the UK and beyond.
4. A Modest US Recession in 2016 Amid global equity
volatility triggered by Chinas slowing growth and a steep drop
in commodity prices, one area of relative support has been the
performance of the worlds largest economy. The US growth
outlook has been convincing enough for the Fed to initiate a
long-awaited tightening cycle in December 2015. Yet with
muted post-crisis growth averaging slightly better than 2%
annualized versus a long-term post war average of 3.2% through
200711 a slide into a technical recession is perhaps not far off,
assuming certain current trends persist.
As of January 2016, the manufacturing sector is in contraction
as measured by the ISM Manufacturing Index. Credit is
tightening. The strong dollar is crimping corporate earnings,
and jobless claims have started to rise.12 Meanwhile, consumers
are holding on to a rising share of their disposable income,13 and
not spending the apparent windfall from low energy prices.
Meanwhile, policymakers slump-busting war chest has been
depleted by years of quantitative easing and near-zero interest
rates. If financial market volatility persists and wallets get even
tighter, two quarters of contraction are a real possibility.
5. Damaging Consequences of Low and Negative Interest
Rates on the Financial Sector At the beginning of 2016 a
substantial share of developed economies citizens were living
under some form of negative monetary policy rates.
Approximately 38% of developed country government bonds
outside the US carried negative yields.14 There were about $1.5
trillion in negative-rate euro government bonds as of late 2015.15
Though nothing disruptive has happened thus far, 2016 could
be the year we start to see some unintended disruptions in the
financial system from these unorthodox conditions.
2

IQ Insights | Our Top 10 Gray Swans for 2016.

For banks, passing on negative rates in effect, charging to

hold deposits could lead customers to conclude it is better just
to hold cash, or use savings to pay off mortgages or other debt.
This would deplete the deposit base on which loans are made
and result in credit contraction, exactly the opposite of what is
intended with lower rates.
Even where rates are not (yet) negative, at the end of 2015
financial stocks in the US rallied on anticipation the Fed
wouldfollow through on a tightening cycle that would improve
interest earnings, only to quickly sell off in early 2016 when
lessaggressive tightening pace was priced in. Negative interest
ratescould sharply squeeze bank earnings, potentially leading
to systemic risk as bank capital erodes.16
6. An Oil Squeeze As Gray Swans went to press, Russia and
several Organization of the Petroleum Exporting Countries
(OPEC) members announced an agreement to freeze crude oil
production at the current levels. Given that current output is at
record levels, the move was a first baby step toward addressing
the glut that has caused prices to plummet 70% since 2014. Still,
like actual baby steps, this was a significant development. Why?
Because addressing the price slump would almost certainly
require exporters to impose production quotas on themselves
a measure that has long eluded them. If they reduce output
enough to burn down much of the 3 billion-plus barrels
currently stored in tanks around the world, prices would
eventually rise. For producers, its obviously much better to
earn more per barrel by selling less oil than to virtually give
away the commodity that many oil-rich economies rely on.
The price plunge, in fact, is largely self-inflicted. As US
producers began pumping millions of extra barrels from
fracking and oil sands, Saudi Arabia the worlds biggest
exporter flooded markets with oil in an effort to undercut
USproducers and guard its own market share. The strategy
hasindeed crippled many higher-cost US producers, while
others have learned to pump crude for less. The collateral
damage, however, has been real pain felt by exporters (see the
next point). Normally flush Saudi Arabia ran a record budget
deficit estimated at 15% of GDP in 2015 when a barrel
generally fetched between $40 and $60.17 The kingdom has
begun issuing debt, and is mulling a sale of shares in the
hugestate oil company or possibly even imposing taxes on
itscitizens.18
The trouble is, even when OPEC has managed to agree to
production quotas, member countries have typically failed
toabide by them. Given the dire status quo for exporters, if
everthere was a time to learn discipline and drive prices up,
ithas arrived.
7. Domestic Unrest in Oil-Exporting Countries Assuming
discipline remains lax and crude prices stay low, another
possible gray swan for 2016 is civil strife in countries whose
quality of life and government budgets depend largely on oil

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revenues. Already, credit default swap prices have risen

dramatically on formerly free-spending Venezuela. Other
possible victims include Nigeria, Brazil or Russia, where tense
internal politics could erupt. Its hard to exaggerate the impact
of declining oil lucre. Crude revenues fund half of Russias
fiscalbudget, and are central to Vladimir Putins power and
ambitions. In Algeria, it would take $111/barrel oil to support
current government spending.19 Popular uprisings in countries
like Venezuela or Nigeria could create unexpected instability
more broadly in Latin America or West Africa. Nigeria in
particular, Africas largest economy, contends with murderous
extremists in the northeast and restive minorities in the
oil-rich Niger Delta. Upheaval could further alienate investors
and leave the region in worse economic shape.
8. Escalating Cross-Border Sunni/Shia Conflict For years,
regional powers Saudi Arabia and Iran have been fighting one
another on proxy battlefields. The Saudis support Sunni fighters
in Iraq and Syria, against Iranian-backed Shiites. Last year,
Saudi Arabia upped the ante by sending its own tanks and
fighter jets to Yemen to fight Houthi insurgents a Shiite
groupregarded by Riyadh as an instrument of Iranian power.20
With Saudi-US ties frayed over the Iran nuclear deal, and with
post-sanctions Iran asserting itself more forcefully, Saudi
Arabia has taken the lead as the most militant Sunni power in
the region. Meanwhile, Irans Ayatollah Ali Khamenei uses the
kingdom as a whipping boy to drum up domestic political
support.21 Tensions escalated in January 2016 after the Saudi
Arabia executed a cleric who was a symbolic leader for Shiite
protesters, sparking protests across the Shiite world; in Iran,
the Saudi embassy was set ablaze, leading to a break in relations
between Iran and several Sunni Arab countries.22 With so much
tension across the region, hostilities could worsen in 2016. An
all-out war between the Sunni and Shiite-led countries remains
a possibility, albeit a remote one.
9. Cascading Sovereign Wealth Funds and FX Reserves
Assets in major sovereign wealth funds (SWFs) climbed
steadily from $3.4 trillion in September 2007 to almost $7.3
trillion in June 2014 according to the Sovereign Wealth Fund
Institute. Thats a pace of more than $500 billion per year in
added wealth, largely supported by current account surpluses
often fueled by natural-resource income.23 Since June 2014
when crude prices began collapsing assets have been flat,
at$7.2 trillion in December 2015.24 In 2016, SWF selling
couldreach an estimated $220 billion, assuming $35/barrel
oil.25 These days, countries are cashing-in their savings to
coverexpenditures formerly funded by natural resource
sales.As theoutflow mounts, selling could depress global
assetprices.Already in the last half of 2015, foreign investors
were net sellers of US long-term assets.26
As for FX reserves, China, which held more than $1.2 trillion
inUS government debt as of December, it is drawing down its
reserves to defend the RMB. While Chinas officially reported

IQ Insights | Our Top 10 Gray Swans for 2016.

Treasury holdings were flat for 2015, holdings out of Belgium

have declined by more than $200 billion,27 which some
suspect28 signals massive Chinese selling of US Treasury bonds
held at Euroclear in Brussels.
When asset owners who had been pumping a half-trillion
dollars into investments each year stop buying and instead
sellhundreds of billions, the impact on asset prices cant
befavorable.
10. Russia Makes Headlines for the Wrong Reasons With
itseconomy in a second year of recession as a result of global
sanctions and plummeting oil prices, Russia could again be
unpredictable in 2016. President Putin has already displayed
apenchant for acting out, seemingly in an effort to distract
focus at home through moves like annexing Crimea, backing
separatists in Ukraine and conducting airstrikes in Syria to
support the Assad regime. With no economic relief in sight
through higher oil prices, further adventures by Russia could
increase geopolitical tension again in 2016. Another possibility:
After many months of painful recession, Russians once again
take to the streets to express their frustration with Putin a
move that could be met with an even more spirited crackdown.

http://www.telegraph.co.uk/news/worldnews/europe/france/11998301/Parisattacks-France-to-call-for-effective-suspension-of-Schengen-open-borders.html

http://www.bbc.com/news/world-europe-35559159

http://www.theguardian.com/world/2015/dec/06/
front-national-wins-opening-round-in-frances-regional-elections

http://news.yahoo.com/un-rights-envoy-says-hungary-debilitatingdemocracy-153839797.html
http://www.theguardian.com/politics/2016/feb/12/
conservative-councillors-call-for-david-cameron-to-campaign-for-brexit

10

Bureau of Economic Analysis. As of January 31, 2016.

11

http://www.tradingeconomics.com/united-states/jobless-claims

12

https://research.stlouisfed.org/fred2/series/PSAVERT

13

Barclays POINT, as of January 31, 2016.

14

http://www.bloomberg.com/news/articles/2015-10-23/
draghi-s-signal-adds-190-billion-to-negative-yield-universe

15

16

http://www.marketwatch.com/story/negative-interest-rates-are-a-dangerousexperiment-warns-morgan-stanley-2016-02-17
http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=18m

17

http://www.nytimes.com/2016/02/17/world/middleeast/young-saudis-see-cushyjobs-vanish-along-with-nations-oil-wealth.html

18

What to do?

19

So what should investors do, given the number of gray swans

complicating the outlook for global markets?

20

Given expectations for heightened volatility, we suggest

investors review the downside protection they have in their
portfolios. This can take the form of strategies with built-in
rebalancing triggers tied to volatility, or managed volatility
strategies that use either a rules-based or alpha-seeking active
management to systematically tilt portfolios toward lower-beta
holdings, among other approaches. For a quick primer, see
SSGAs Tail-Risk Strategies: A Two-Minute Guide.

http://www.wsj.com/articles/
oil-producing-countries-pummeled-by-40-crude-1449759979
http://www.nytimes.com/2015/04/10/world/middleeast/yemen-fighting.html
https://corporate.eurasiagroup.net/item-files/Top%20Risks%202016%20FINAL.pdf

21

http://www.nytimes.com/2016/01/03/world/middleeast/saudi-arabia-executes-47sheikh-nimr-shiite-cleric.html

22

Sovereign Wealth Fund Institute, as of February 29, 2016.

23

http://www.swfinstitute.org/sovereign-wealth-fund

24

http://blogs.barrons.com/focusonfunds/2016/02/01/
selling-by-sovereign-wealth-funds-is-a-huge-headwind-for-stocks

25

http://www.marketwatch.com/story/heres-why-speculation-that-china-is-massselling-us-treasurys-could-be-true-2016-02-17?mod=MW_story_recommended_
default&Link=obnetwork

26
1

J.P. Morgan, as of January 31, 2016.

J.P. Morgan, as of January 31, 2016.

http://www.bloomberg.com/news/articles/2016-02-15/
china-s-bad-loans-rise-to-highest-in-a-decade-as-economy-slows

http://www.bloomberg.com/news/articles/2016-02-16/
china-s-new-credit-surges-in-january-on-seasonal-lending-binge

Barclays POINT, as of January 31, 2016.

State Street Global Advisors

http://ticdata.treasury.gov/Publish/mfh.txt

27

http://www.zerohedge.com/news/2015-05-18/revealing-identitymystery-belgian-buyer-us-treasurys http://www.marketwatch.com/story/
heres-why-speculation-that-china-is-mass-selling-us-treasurys-could-be-true-201602-17?mod=MW_story_recommended_default&Link=obnetwork

28

IQ Insights | Our Top 10 Gray Swans for 2016.

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