Brexit negotiations ending up a roaring success, Donald Trump losing November’s election and Russia flexing its geopolitical muscle more than anyone could expect are some of the events that are entirely possible but are being ignored by the market. 
This the view of Mouhammed Choukeir, chief investment officer at Kleinwort Hambros, in his annual ‘Tails of the Unexpected’ report – which looks at each year’s unlikely, but feasible, events not priced by markets.
“Markets are exquisitely unpredictable and, each year, events – financial, economic, geopolitical or otherwise – occur which few see coming, but cause powerful ripples to the prices of securities,” he said. “Instead of consensus-tinged forecasting, we continue an annual tradition of exploring what unlikely but feasible events are not priced by markets in the year ahead.”
Below, Choukeir highlights five potential events, examining what the consensus view is not pricing in, the possible market reaction and how they relate to Kleinwort Hambros’ portfolio positioning.
Swirling sterling – Brexit negotiations go extremely well
Currency markets are pricing in another bumpy year of negotiations between the UK and the European Union, as shown by fizzling out of the post-election rally in sterling. The pound has fallen from the $1.35 it hit in the immediate reaction to the election, as the market realised that this is the start of the country’s negotiations with the EU, not the end, and that trade talks could potentially last for years.
However, Choukeir said: “The consensus may not be pricing in sheer exhaustion. Most minds are anchored by the recency bias of the last three years, where much ‘noise’ has been generated by missed deadlines and crossed ‘red lines’.
Performance of sterling vs US dollar since Brexit referendum
Source: FE Analytics
“However, following the original referendum, and now a general election, it is clear most British people want to leave. Most Europeans want this over with too, with little appetite for ‘punishing’ the UK at the cost of prolonging the morass.
“And while trade deals usually take longer, a negotiated settlement may be easier in this instance given near-identical starting positions on many rules and regulations. It also gives the UK the ability to cut taxes and regulatory red tape, actually breathing life into the idea of the ‘Singapore on the Thames’.”
Under this scenario, sterling could hit $1.75 and €1.55 as Brexit happens faster than the market expects, while domestically focused UK stocks such as mid-caps rally hard. But government bonds may sell off aggressively as investors dump safe-haven, low-yielding assets and invest in riskier ones.
In its strategies, Kleinwort Hambros has a net bias to risky assets and an overweight to UK equities. It has also hedged part of its US equity positions and all gold holdings against a rise in the value of sterling.
Trading up – A comprehensive trade deal with China is agreed
Although few commentators are expecting a recession in 2020, not many are forecasting an economic boom either and the consensus is for “yet another year of slow, meandering economic growth across the world”.
Kleinwort Hambros noted that this is largely down to depressed manufacturing output and poor capital expenditures by corporates unwilling to invest, especially while the US and China have a tense trade relationship.
“US and Chinese negotiators appear to have closed a ‘phase one’ trade deal. They are also strongly incentivised to complete ‘phase two’ given the US election year on one hand and a Chinese social contract predicated on growth on the other,” the firm said.
“Moreover, while economies will continue to receive powerful support from central banks, there also is evidence fiscal policymakers will be more active – this could prove a game-changer. Far from a recession, global economies may well re-enter expansion mode from the current ‘slowdown’ stage.”
If this is the case, global GDP could jump to around 5 per cent while risky assets such as equities and high yield debt would perform well. Kleinwort Hambros said it does own some defensive assets that would suffer in this scenario but does have a risk-on stance in general.
Private inequity – Private equity suffers under weight of expectations
Private equity has enjoyed a strong run over the past decade, in terms of capital raised and deployed as well as the distributions back to investors. Total buyout value jumped 10 per cent at the end of 2018 to hit $582bn (including add-on deals) globally, marking the strongest five-year run in the industry’s history; many have expectations that private equity will deliver high double-digit returns.
“Low interest rates and steady GDP growth in the US and Europe have helped the industry, but the real juice in returns has come from selling assets acquired at cheap valuations in the years after the great financial crisis at much headier multiples now,” Choukeir said.
Performance of average private equity trust over 10yrs
Source: FE Analytics
“This thunderous recent performance has diverted waves of new liquidity towards the asset class: a decade ago, a $1bn fundraise would have been notable; today, some funds raise more than $100bn. Dry powder, or capital which is raised but not yet spent, is above a record high of $2trn. This has led to a transformed landscape: PE firms are forced to deploy ever more money not only at richer valuations, but also on increasingly speculative underlying investments. This is a dangerous convergence of factors.”
If there were a disorderly wind-down of some large private equity funds, Kleinwort Hambros believes the wider impact would be quite limited as the asset class does not pose the same systemic risk as mortgage-backed securities did in 2008. However, it could still create a risk-off environment that would see assets like high-yield bonds suffer, while a fall in private equity valuations could cause a knock-on drop in publicly traded companies.
Kleinwort Hambros thinks the coming decade will be more challenging than the past one for private equity returns, adding “2020 may well be the year the unravelling begins”. With this in mind, the investment house has no exposure to private equity in its flagship portfolios and “remains vigilant” about valuations in public equity markets.
Donald Ducked – Trump loses November’s election
If the bookies are to be believed, Donald Trump has just over a 50 per cent chance of winning this year’s presidential election. History suggests that prevailing economic conditions are the most important factor for an incumbent president seeking re-election and Trump has a lot in his favour in this regard: unemployment is at a record low, wages are rising briskly and the Federal Reserve says there is just a 25 per cent chance of a recession in 2020.
“Usually, established Western democracies see policies tilt between ‘centre-left’ and ‘centre-right’. This time may well be different, with a Democratic victory predicating a substantial leftward lurch in public policy and thus a big increase in current taxes,” Choukeir added.
“Remember, president Trump slashed corporate taxes dramatically in 2017; a return to even the pre-Trump status quo will cause post-tax corporate earnings to contract.”
If the Democrats were to win the election, then there would be substantial rise in corporate taxes no matter who their candidate is – which would cause a contraction in US corporate earnings and lead to a sell-off for US equities, with the strong chance of this spreading to global markets. Investors would likely rotate into government bonds, causing their yields to fall.
Kleinwort Hambros noted that government bonds offer poor value in absolute terms at present, although it regards them as essential in helping to risks from equities and other risk-assets in multi-asset portfolios. However, in a global sell-off the firm would look to reallocate back into equities “when valuations are cheap, momentum turns positive and sentiment is still oversold”.
Putin in a shift – Russia flexes its geopolitical muscle
The consensus view is that 2020 will be another year of range-bound oil prices. Choukeir pointed out that even the assassination of Iranian general Qasem Soleimani in early-January only caused an increase of around 5 per cent in the oil price.
“When it comes to oil prices, many focus on the Middle East. However, Russia may actually be the swing factor,” the chief investment officer said.
“In the last decade, Russia has unshackled itself from its post-Cold War funk and reasserted itself on the global stage in a major way: Ukraine’s annexation; critical backing for the Syrian and Iranian regimes which has tilted the balance of power in the Middle East; US general election interference in 2016; alleged assassination attempts of former spies, including in the UK; huge African investments, and thus influence.
“Much of this would have been unthinkable in 2010. At the start of 2020, a strategic attack on a missile bunker in the Baltics or similar is also unthinkable, but that is why it’s not priced in. The risk is also heightened as the US president will be under huge pressure in an election year to ‘rectify the sins’ of Russian interference in 2016.”
Price of Brent crude over 10yrs in US dollars
Source: FE Analytics
Kleinwort Hambros said the potential market reaction of Russia and Nato looking like they are the brink of an armed conflict could be significant, given that Russia produced about 11.4 million barrels of oil per day in 2019, accounting for 11 per cent of world output. Any threat to this could cause oil to shoot to $150 a barrel, creating a spike in headline inflation.
Meanwhile, equities would sell-off but any safe-haven rally in bonds would be crushed by soaring inflation. Gold, however, “would go through the roof”.
Choukeir concluded: “We have all been dulled by the constant cacophony of geopolitics. Indeed, there is much evidence that it tends to be a red herring in terms of risk allocations and thus best ignored for asset allocation purposes.
“However, it certainly impacts certain markets, such as commodities, if they’re directly in the line of fire (pun intended). We have a large allocation to gold particularly to help insulate portfolios somewhat in the event of such ‘black swan’ events.”