These things could go wrong in 2016

These things could go wrong in 2016

These things could go wrong in 2016 On a clear March night in Iraq, the desert plain of the Faw peninsula and a Kurdish village near Syria and Turkey go up in flames. The next morning, Islamic State claims responsibility for the destruction of the country’s major oil pipelines.

The world immediately loses 3.5 million barrels of daily exports. As Iraq struggles with repairs, violence erupts in the oil-rich region of the Niger Delta, Algeria descends into chaos on the death of its president and there’s a coup in Venezuela. Bloated inventories protect the global economy for a while, but the industry is operating with the thinnest capacity cushion in years. Crude eventually tops $100 a barrel. The Federal Reserve reverses its rate-raising policy to avert a global recession.

Impossible or plausible?

Investors can’t ignore this or other so-called Black Swan scenarios following a year that surprised the world with record refugee flows and brutal terror attacks. In 2016, unexpected events will take on heightened importance as the Fed ends an era of ultra-cheap credit. Markets will lose the cushion that’s shielded them from geopolitical shocks such as the Arab uprisings and the annexation of Crimea.

Little Ammunition

“There is very little ammunition that can be applied to mitigate these kinds of risks," said Tina Fordham, Citigroup Inc.’s chief global political analyst. "Central banks still have the most bullets and we have already crossed the Rubicon into extraordinary measures.”

From a maverick winning the U.S. presidential election to Britons voting to quit the European Union to hackers bringing down Wall Street, Bloomberg discussed a range of high-impact events with dozens of former and current diplomats, economists, investors, geopolitical strategists and security consultants. The scenarios, also presented in this interactive graphic, were reviewed and ranked by 119 economists in a survey.

Top Three
Just over one-quarter of them chose oil rising on Islamic State attacks as the biggest challenge to the global economy. The runners-up were the U.K. exiting the EU and a cyber attack taking down the financial system. Nightberg, a New York-based independent global macro research firm whose clients include hedge funds, assigned these three events probabilities of 25 percent, 20 percent and 10 percent, respectively.
Some risks are well known. 

If the Fed raises rates too fast, capital could flee emerging markets and sovereign defaults may spread. If China’s economy is in worse shape than expected -- as the drop in demand for metals and other mined goods suggests -- that could prompt civil unrest that chips away at the authority of the ruling Communist Party. Latin America’s decline could continue, with Brazil diving into full-blown depression as it hosts the Olympics and Venezuela morphing into a failed state.

Dispiriting Times

“We’re going through a period of dispiriting global economic growth which highlights the costs and distortions created by years of unorthodox policies in a number of major economies,” said Alberto Ramos, chief Latin American economist at Goldman Sachs Group Inc.

Societe Generale SA, in its yearly chart of Black Swan risks, said a China hard landing -- a severe slowdown after a cycle of fast growth -- could tip the global economy into recession. The bank assigned it a 30 percent probability. 

“When China bites off more than it can chew that’s a big bite,” said Paul Brewbaker, former chief economist at the Bank of Hawaii who now runs consulting company TZ Economics.

There’s an element of “Whack-a-Mole” in conjuring Black Swans but when they come true, they are a life-changing “lesson in humility” for policy makers and markets, said Jacob Funk Kirkegaard of the Peterson Institute for International Economics in Washington. He cited the 2008 financial crisis, the Arab Spring and the Fukushima meltdown as unexpected events that were misread at the time.

Trump Triumph

The U.S. could deliver one the biggest surprises of the year if Hillary Clinton unexpectedly drops out of the presidential race, clearing the road to the White House for an outsider such as Republican Donald Trump. The billionaire promises to enlarge the military, prohibit Muslims from entering the U.S. and build a wall along the border to keep out Mexican immigrants.

A Republican in power would pour more money into defense, especially with rising security challenges such as Islamic State, the Syrian conflagration and Russian adventurism, according to George Ferguson, senior aerospace analyst at Bloomberg Intelligence. Among the beneficiaries of those policies: Raytheon Co., Lockheed Martin Corp. and Boeing Co., he said.

An untested commander-in-chief accusing China of manipulating its currency and Mexicans of stealing jobs raises the specter of a trade war and may lead to a flight to safe investments like bonds, according to Nightberg.

“It is difficult to envision any type of policy coherency emerging from a Trump administration,” said Tom Fullerton, a professor of economics and finance at the University of Texas at El Paso.

Merkel’s Fall

In Europe, investors fear German Chancellor Angela Merkel could be ousted over her emphatic open-door policy as a wave of terror attacks and growing xenophobia ensnares the continent. That increases the chances of a successor with few qualms about abandoning Greece and other peripheral nations to their own currency fates.

“If Merkel were to lose her job, all hell would break loose,” said Nicholas Spiro, managing director at Spiro Sovereign Strategy, a London advisory firm assessing risk in developing economies. A chancellor such as Finance Minister Wolfgang Schaeuble, a fiscal hawk, “would probably be less supportive of full-blown quantitative easing, less supportive of Greece, less supportive of bailouts.”

Liquidation Wave

A big EU crisis could lead to a strong selloff in equity markets, a favored destination for investor capital in the past years, and a considerable weakening of the euro, Nightberg predicts. With capitals on high-security alert, shuttered borders would hit trade and damp already anemic growth.

UBS Group AG, in its "Year Ahead" note to clients, flagged the rise of extremist political parties in Europe and Islamic State extending its territorial reach among the potential dramas that would hurt consumer confidence and spending. In France, the rise of Marine Le Pen’s National Front is a barometer of growing anti-immigration sentiment.

“If for some reason Europe is unable to defend itself from terrorism, people would reduce the allocations,” said George Hoguet, a Boston-based global investment strategist at State Street Global Advisors, which has $2.4 trillion under management.

‘Brexit’ Now

The malaise could also infect the U.K., where polls show euro-skepticism is picking up at a time when Prime Minister David Cameron is trying to negotiate better terms for staying in the 28-member club. A referendum could be held as early as next year; banks from UBS to Morgan Stanley are warning clients to pay attention to the chances of the "Leave" camp winning.

Top bankers have said a vote for EU departure could reduce London’s role as the European center of finance. Ripple effects could include a renewed push for independence by the Scots and other separatist movements.

One scenario transcends borders: A cyber-attack wreaking havoc on a major financial system.
Extremist groups such as Islamic State could team up with Eastern European criminal hackers-for-hire to launch attacks on electronic-settlement or trading platforms. Everything from online bank accounts to computer-controlled electrical plants and power grids is at risk. 

Cyber Drill

High-profile data breaches at JP Morgan Chase & Co. and Sony Corp. highlight these vulnerabilities. Just last month, the U.S. and the U.K. carried out ajoint drill to test the resilience of the world’s two dominant financial hubs.

“In the past, bank fraud was used to steal money: In 2016, we’ll see these techniques used to finance terror, ” said Mark Gazit, chief executive of ThetaRay, an Israeli startup focused on threats to critical infrastructure. “I do see power outages and an enormous breach of privacy.”

Some Black Swans can have positive overtones. An example: Russian President Vladimir Putin could become a peace broker in war-torn Syria. He stepped in after Islamic State claimed responsibility for the downing of a Russian passenger plane over Egypt and the massacre in Paris, two seminal events that laid the groundwork for closer military collaboration against a common enemy with headquarters in Syria.

If Putin can work with the international community to bring about a political transition in Syria -- though it remains to be seen how stubborn differences over the future of President Bashar al-Assad can be settled -- chances rise that sanctions can be lifted down down the road, easing Russia’s path out of recession.

“Imagine if three months ago it was possible to think that the U.S. and Russia could work” in the same direction, the United Nations special envoy for Syria, Staffan de Mistura, said this month in Rome. “Maybe there is no light at the end of the tunnel, but now we have a tunnel.”

Bloomberg News
Flavia Krause-Jackson and Javier Blas
--With assistance from Taylor Hall, Gabrielle Coppola, Sangwon Yoon, Joshua Robinson, Elena Popina, John Follain, Chris Strohm and Michael Shepard