A Chinese policy mis-step, the emergence of state-backed cryptocurrencies and a more joined-up approach to European fiscal policy are among the potential ‘grey swans’ – high-impact but improbable events – that could take place in 2020, according to State Street Global Advisors. 
Lori M. Heinel, deputy global chief investment officer at State Street, said the firm has highlighted five grey swans – alternative scenarios outside the scope of its base case “but not beyond the realm of possibility”.
“The market may discount their likelihood, but if any one were to happen, it has the potential to materially move markets,” she said.
As it stands, the firm’s base case scenario is for the global economy to grow at 3.5 per cent in 2020 – barring any new geopolitical shocks – and for the outperformance gap between the US and the rest of the world to shrink.
But the emergence of any of the below grey swans would have significant impact on its base case.
‘A spirit of fiscal cooperation builds in Europe’
The first grey swan event that could impact markets is in Europe, with Heinel noting that after years of low growth, eurozone members might collectively turn to fiscal stimulus to boost economies.
“Although the European Central Bank has been providing ample monetary stimulus, the region’s economy has been stuck in low levels of growth,” she said.
“As a result, European equities have lagged their US counterparts and continue to trade at deep discounts relative to the US. However, with large swaths of debt still reading at negative yields, it appears that monetary stimulus alone is not enough.”
However, although further investment and deficit reduction has found support from the ECB and Organisation for Economic Cooperation & Development (OECD), convincing members to act might be more difficult.
“The Netherlands, Sweden, Ireland and over a dozen more countries have capacity for fiscal stimulus in addition to Germany under the ECB and OECD proposal,” said the State Street strategist. “A series of small steps could aggregate to effective economic stimulus.”
Any such move could “pique investor interest and likely spark fresh risk appetite for European equities”.
‘Chinese policy choice roils global markets’
While Chinese authorities were delicately balancing multiple objectives heading into 2020, said Heinel, past experience shows that even small technical policy errors could have global implications.
And this could emerge from China’s broader geopolitical ambitions or in the management of the domestic financial system.
“For the US-Chinese trade de-escalation to hold throughout the year, China must continue to keep its trade negotiations separate from other likely sources of tension with the US,” she explained.
“However, Beijing could make decisions that could upset this sensitive balance.”
Heinel added: “Deleveraging the Chinese financial system requires equally delicate balancing. Beijing has allowed more credit defaults to take place (a positive trend), but the risk of a default shock persists, which could lead to broader credit retrenchments.”
However, volatility in the Chinese bond market or among its financial institutions could prompt investors to reassess China’s risks and could result in a sell-off.
‘The Federal Reserve lets inflation run hot’
Another potential grey swan scenario could emerge if the Federal Reserve allows inflation to run above targets during economic expansions.
While inflation has been largely lacking in the post-crisis environment, the State Street deputy investment chief said a scenario could emerge where it not only exceeds targets but takes investors by surprise.
“The investment implications triggered by this grey swan depend in part on the economic backdrop. If economic growth remains robust and corporations get some pricing flexibility, equities could hold their value,” she said. “Conversely, if inflation picks up against a backdrop of slowing growth, fears of a return to the 1970s’ stagflation scenario would weigh heavily on equities.”
‘Technology gets de-FAANGed’
While the tech mega-caps – Facebook, Amazon, Apple, Netflix and Google-parent Alphabet – have enjoyed an unprecedented run and continue to push boundaries, so the potential for major regulatory action becomes more likely, said Heinel.
There are three major issues putting such firms in the ‘regulatory crosshairs’: antitrust, taxation, and ownership of digital assets & privacy.
“We do not see risks of a new regulatory environment being priced into today’s market valuations,” she said. “Historically, valuations have declined once a regulator acts based on expectations of lower profit margins and/or restricted growth following a resolution.
“Technology stocks tumbling would be a negative event for equities overall in the very short run as investors reset their growth expectations especially given the fact that FAANG stocks alone have accounted for more than one quarter of the 190 per cent in cumulative return of the S&P 500 index since 2012.”
‘Cryptocurrencies come of age’
The final grey swan would be a “seminal moment in financial history with far-reaching consequences”, according to the State Street strategist: the implementation of a state-backed digital currency.
While digital currencies such as Bitcoin have given rise to stablecoins linked to sovereign currencies, central bank digital currencies are currently still in development stage.
“The introduction of a legitimate digital currency could be highly disruptive to the global payments system,” said Heinel.
“It holds the potential to have an impact on conventional safe-haven currencies and shift global asset flows, the direction of which (positive or negative) depends on the country issuing the digital fiat currency.”
Although the US is less likely to create a digital dollar, the People’s Bank of China has already indicated plans to launch a digital yuan.
This would help China become a more dominant player in global finance, said Heinel, and become more prominent in the Asia-Pacific region.
This could weaken the Japanese yen and put pressure on the US dollar and gold prices, over time.
“The bigger question is what risks the disintermediation of currency could bring to the financial sector,” she added. “The ability of residents and non-residents to hold accounts with the central bank could upend existing business models for banks and other providers.
“And even if China’s digital yuan were to remain a regional phenomenon, the implications for other global financial institutions could be grave.”