Market Insights

Divorcing Couple Have Row. Palace Prepares Statement.

Usually, that wouldn’t be much of a headline. But when the couple are Theresa May and Jean-Claude Juncker, it’s splashed right up there on the front page. Much emotion has already been spilt over the leaking of last week’s tete-a-tete dinner, where Theresa was apparently “in another galaxy” for her views on Brexit. Eyes rolled from Remainers, froth surged forth in the Eurosceptics, and everyone declared doom. Either we would be fighting them on the beaches for their insolence, or begging at their sleeve for forgiveness. In other words, this meeting did nothing to change the opinions of either of those groups.

And this, friends, is where we will find ourselves for the next two years. Forget Fake News, this is going to be the realisation that News is only ever perceived by the eye of the beholder. If you never agreed with Brexit in the first place, you’re panicking that you’re being dragged into something you didn’t choose; if you always wanted to leave the EU, you’re ready to greet every defeat as victory. Therefore every news story will have a different tinge, depending on which group you fall into. It was ever thus. Tories evil austerity cuts, or Labour bankrupt Britain? Reporting the same facts, but with a different spin.

This didn’t use to bother financial markets. Cutting the deficit in half was cutting the deficit in half; no judgement made on whether it was being done in the right way. It would just mean that interest rates could remain lower for longer as the country got its house in order. If it were credible, and inflation remained in check, the yield curve would respond by flattening. Easy.

So what does this Brexit dinner row mean for financial markets?

So far, not much. In fact, the market has decided it couldn’t give two hoots about political risk. What with Macron 90% priced to enter the Elysee Palace on Sunday, a US government shutdown avoided, and Trump left languishing in his Twitter echo chamber, why worry? In fact, why worry about anything at all? Stocks are back up to record highs, safe havens like bonds and Gold are easing off their highs, and currencies remain in relaxed ranges.

Concomitantly, volatility measures are plunging. The so-called Fear Gauge, the VIX, is now at its lowest since February 2007. I’m told that of 6,871 daily observations for the VIX since it started trading in the 90s, there have only been 14 observations lower than where it traded yesterday. Certainly, our favourite cross-asset vol chart shows that equity volatilities are back to where they were in the doldrums of 2014:

Currency and bond volatility haven’t fallen as far due to less QE going on and currencies now being used as pressure valves for economic shifts. So if the gap between FX/Bond vol and Equity vol narrows then we know that the world has decided we are going back to 2014 style somnolence. No risks on the horizon, everything as it was, keep on keeping on.

But hang on a minute! What about that row? That’s not just a political argument, it could affect the very fabric of both the UK and Europe’s economies, with knock on effects for the rest of the world!

Aye, here’s the rub.

Understanding the apathy to this event is key for understanding how the rest of this year pans out. Last week I met an investor who put her head in her hands and wailed “when can we stop talking about politics??”. The current lack of fear is not because there is nothing to be worried about; it’s because we don’t know how to deal with those worries. The risk of a Fed hike in June can be priced and measured; the risk of no deal between the UK and EU cannot. And if the market can’t price something, it often chooses to ignore it until it becomes something that can be priced. As long as it’s not systemic, of course. It’s a bit like mortgage backed securities in 2007. All going fine until the day that someone wakes up and can’t price some CDOs (BNPP on 9 August 2007 for those who can’t remember).

So it is likely investor psychology runs like this:

  1. Ok so those political event risks last year caused some wobbles; thank god all of them are out of the way now
  2. In fact, the right reaction to those wobbles was to buy the dip; oooh so now I’m going to buy without a dip or even before the event risk is over this weekend
  3. Who cares about the UK PM or Donald Trump having a row? That’s just politicking, playing to their galleries, they never get anything done anyway
  4. And assets are going up, and I need more of them! I’ll just buy some tail hedge if anything pops up on the horizon unexpectedly

And on and on this goes… until:

  1. Wait, are these guys making decisions that might actually affect the price of assets?
  2. So the valuation of everything I own is based on a shifting landscape that I can’t quantify?
  3. ……*exit stage left*

To move from the first stage to the second, we need to reach peak greed. Brace yourself for many more observations of the VIX lower than here. We may be at the same levels as we were in February 2007, just six months before the credit crunch began; but we are far from the same levels of euphoria. Having spent a couple of years wondering what your portfolio might look like if the VIX hits 25, maybe now we have to consider what it would look like at 5…. And then at that exact same moment be ready for the violent flip back to reality. VIX 5/50 straddles anyone??

Shutdown

Emmanual euphoria continues… With the market certain that Macron will win the French Presidency, and thus the year’s big political risk out of the way, everyone can sell their worthless tail risk insurance, volatilities can fall, and then everyone gets a signal to plunge into ever more risky assets. Or at least, that’s the narrative for now. At some stage we will reach peak Greed, but for that we need the complete absence of Fear.

There is currently little fear about the prospect of a US government shutdown. This Friday is the deadline for the government to run out of funds, following the rollover of the March 15th deadline by the use of temporary “extraordinary measures”. We have been here many times before, and even when the government did have to shut down in October 2013, it barely hurt the markets (or indeed the economy). Hence the general shrug of disinterest. But this time around, it happens to coincide with the new President celebrating his First 100 Days on Saturday. Again, we might shrug that this is an artificial meaningless construct, coined relatively recently by FDR in 1933. It’s just something for the newspapers to fill copy with, isn’t it? Irrelevant to actual power.

That would be to underestimate its importance to the first Reality TV President. From Fake News to Alternative Facts, his whole Presidency is about what is said about him. He knows that using Twitter to talk directly to The People, His People, got him into power in the first place. Now he’s trying to figure out how to wield that power, what with it operating very differently when it comes to getting things done. Executive Orders haven’t really worked; bullying for a repeal of Obamacare failed; so what next?

Ahh it’s all about the Art of the Deal (available in all good bookstores). This title of Trump’s 1987 book is like a red rag to Congress’s bull. They chuckle that he might know how to negotiate in business, but he’s a novice in the art of political deal-making. Hence we have Trump last week demanding that funding for the Wall must be part of this week’s Budget deliberations; but backtracking from that last night. Hey, he’s happy to wait until later this year. He’s relaxed. And that Obamacare repeal that he wanted? Members of the Freedom Caucus who torpedoed it warned now “it’s an awfully tough dream…You just simply begin to run out of days in this week, given the fact that we have this big funding issue coming up at the end of the week” – leaving the White House Press Sec to explain yesterday that they’re so relaxed they won’t set an “artificial deadline” for the repeal.

So far, so relaxed, so good, right?

Well, it’s hardly as if Trump has had the best relationship with his own party, who didn’t even want to give him the nomination. Now he has to try to build bridges with the Democrats, while keeping the Republicans on board. Meanwhile they all have their own battles to fight, with elections next year.

Last week Paul Ryan, Speaker of the House of Representatives, gave a very energetic speech about everything that he wanted to achieve. Make no mistake, he also wants tax reform and a repeal of Obamacare, as Trump does – but he’s been taking the flak for the inability to deliver anything so far. His problem is that everyone wants something for nothing: give this, take from that, keep it revenue neutral. He was clear in his speech last week that healthcare reform has to come before tax reform or they won’t be able to pay for it. But this sequencing is tripping them up as no-one wants to budge to make a deal. 

Again, this might all seem like irrelevant detail. Who cares?

Well, we are heading into a deadline in which everyone in the US political system has something to lose, as they also desperately try to find something to gain. Throw in a US President who’s a never held elected office before, who is hitting the 100 day benchmark with a record-low approval rating, and the Art of the Deal could look pretty ugly. Never rule of brinkmanship or impatience throwing a negotiation off course. And never rule out that at the last minute it all comes together. We are due a volatile end to the week.

The Earthquake Continues…

So it’s Macron v Le Pen, as the polls predicted. And so, the logic goes, as the polls show Macron steadily beating her in a 65% v 35% showdown, we can be all but certain that Emmanuel Macron will be the next President of France. A man who has never held elected office before; who effectively ran as an independent; who comes from a business background. If you’re looking for parallels to Trump, look no further.

Some claim the failure of Le Pen in France and Wilders in the Netherlands to poll better is a sign that the EU hasn’t signed up for the populism that’s ‘sweeping’ the UK and the US. This would be to misunderstand the sentiment that’s doing the sweeping. It’s a clean brush that the voters are desperate for. Out with the old, in with the new. Get rid of the establishment. They’ve failed. They profiteered as they preached austerity to those with less power. The tremors from the financial crisis continue. There’s a straight line from the Occupy movements to the complete restructuring of politics across the globe, driven by the deliberate asset-price bubbles stoked by the world’s central banks as they boosted the already asset-rich 1%. Macron is just the latest instalment.

The problem for the new independents is that they can struggle to govern: legislating requires gaining support and consensus. They may have got into power on a wave of anti-establishment sentiment but they need to use the institutions of the establishment to exercise that power. Hence Theresa May calls an election in order to shore up her position. Macron needs his almost inevitable coronation to deliver a momentum that puts his newborn party into pole position in June’s legislative elections. Meanwhile Trump now has to spend next week trying to prove he’s achieved something in his first 100 days – and avoid a government shutdown while doing so.

This means that political risk isn’t going away. But it is changing. We have seen that the polls are more reliable when they forecast proportional systems – they slipped up over electoral colleges and first-past-the-post but were within the margin of error on the UK referendum and much better on the Dutch and French votes. The market is learning from this. But now it must learn how governing actually takes place.

We’ve already been into and out of Trumpflation euphoria; the Obamacare repeal and mishandled executive orders mean we’re now questioning just what the President can actually get done. Next week, if the shutdown comes to pass, we will see just how hard it is when a party turns in on itself. In the months to come, we could see the UK Conservative Party suffer a similar fate: just because Theresa May will likely end up with the biggest majority in decades, doesn’t mean she won’t face further brickbats from within it. If anything, the absence of an opposition might embolden the party’s internal opposition.

These lessons are yet to come. For now, the market will be relieved. It is still wedded to the narrative of the past 10 years: what are central banks doing and what does that mean for volatility? In other words, how much of the carry trade can I have on? And we just knocked down one big event risk, so hurrah, fill your boots, buy the dip, sell vol, wear diamonds. The biggest winner from this weekend will likely be the South African Rand or the Mexican Peso.

What would throw this off course?

  • An overly hawkish ECB on Thursday – they will likely sound optimistic about the economy, but by the time they speak, German yields could have spiked significantly higher as event risk is unwound
  • That aforementioned US Government shutdown – and disappointment over Trump’s bigly tax reform plans that he has lined up for his first 100 days
  • A resurgence by Le Pen in the 2nd round polls – This will likely happen at some stage
    • Macron has ended tonight being endorsed by every single establishment figure: in an anti-establishment mood, could this hurt him?
    • Could those who released details of Fillon’s corruption turn instead to Macron and unearth some disturbing facts?
    • 41% of the 1st round votes were for extremist parties – Macron can’t rely on the “left-wing” Melenchon voters naturally to turn to him, but will they turn to Le Pen or will they abstain? (charts below from the FT in March and Ipsos on Friday)


In the very short term, the Euro may be prone to buy rumour/sell fact – this was the outcome the market had expected and there will be a weekend gap to be filled which could take the Euro back down again. But the positive impact on risky assets will continue – until the aftermath of these political earthquakes becomes better understood.

Zut Alors, et encore…!

And now people want to talk about it…. so let’s get some things straight.

In recent history, France has happily protested against the political classes and the European project:

  • In 2002, Marine Le Pen’s father caused a political “thunderbolt” by making his way into the second round against President Chirac; he gained 16.9% vs Socialist PM Lionel Jospin’s 16.2%
  • Opinion polls going into that election showed Jospin on ~17%, Jean-Marie Le Pen on ~13%
  • In the 15 years since then, Marine has softened the National Front’s brand, even going so far as to eject her father from the party, and is currently polling around 23% for the first round
  • In 2005, France rejected the European Constitution in a referendum, and the changes to the EU only came about after the Lisbon Treaty was accepted in 2007 – which had to be enacted by parliamentary votes and not by going back to the people
  • The Constitution was rejected even though post-vote polling showed that >90% of voters supported the EU; the reasons against it were varied but included those who wanted to use the referendum to give a shock to the ruling elite
  • The French electoral system magnifies this urge. In the first round, it’s said that the French vote with their hearts, but in the second round with their heads.

And how their hearts must be feeling. For those of you reading in the UK, imagine going into an election where last night police officers were shot dead in Oxford Street. Where last year, a suicide bomb was detonated outside Wembley Stadium as the England team were playing with our Prime Minister inside. Where a gig in the West End was destroyed by terrorists killing the audience. Where those terrorists sprayed restaurant goers in Soho and Leicester Square with bullets. Where a van mowed down families enjoying the sunshine on Bournemouth beach. Where journalists at Private Eye were murdered in their office.

This horrific exercise of the imagination doesn’t seek to belittle the trauma of the French: only to make it more understandable when you consider how people might vote this weekend. Just looking at the polling numbers would fail to appreciate the mood of the French people.

Markets struggle with this, and right now, they continue to believe the risk of market dislocation from this election is low – and manageable.

The Dutch vote calmed some nerves by a poorer than expected showing from populist Geert Wilders. But this is to misunderstand the impulse that is taking place across the developed world. It’s not populism per se, but rather a surge towards the anti-establishment. Geert Wilders had been on the political scene for decades; the anti-establishment sentiment came out in the fact that a record number of parties contested the election. The Dutch proportional electoral system meant that it was possible to register a very specific protest vote: it didn’t need to focus in onto just one party. For example, the party representing Turkish interests managed to gain 3 seats.

Emmanuel Macron is just another example of this. Cleverly setting himself up as an independent, with a whole new party, he has been able to shed his attachment to the previous failed administration. This, despite his background as an Economy Minister in that administration, plus being a former banker and Enarque. We will find out on Sunday just how well he has shed his establishment skin. But then the question will become how he will govern, with his party unlikely to have enough machinery to win the legislative elections in June. Will his Prime Minister come from the Republicans, or even the National Front?

The event risk for European assets doesn’t end this weekend. The question is: how well are portfolios prepared for this outcome? If you fear complacency, consider EUR/JPY downside… but if you believe France is a sideline issue for a reflating world, then consider buying that dip! Which side are you on? Answers on a postcard pls!

France? BOF!

Zut alors, just 3 days to go until St George’s Day! Oh and the first round of the French election. You’d be forgiven for thinking the market had already heaved a gallic style shrug over this pathetique little event risk, and that deciding in which pub to partake of your patriotic pint was the key consideration of the weekend. Just look at how overnight vols have subsided over the past couple of months [kindly provided by @JeremyWS on Twitter]:

So the volatility expected in EUR/USD over the night of the 1st and 2nd round of the French elections is around 40% and 35% respectively. Ahead of Brexit, GBP/USD equivalent volatility was more like 150%; for the US election in EUR/USD more like 100%. Either way, the point is clear: we may be expecting some market movement, but nowhere near as much as we saw last year.

This has largely coincided with the surge in the polls by “market friendly” Macron (and even the resurgence of Fillon). The narrative thus far is that someone the market likes will make it through to the final round, and then he will go and win that one too. Nothing to see here, please move along. In fact, haven’t those political risk events from last year also determined that any kind of crash in risky assets is over in but a flash – so if anything, you’d want to be ready to sell vol / buy carry / wear diamonds?

This explains why the absolute level of vols has fallen from the highs. But more interesting is the relationship between the two lines – expected volatility for the two rounds of the election has converged. In other words, the outcome of the 1st round is expected to be as volatile as the outcome of the final round. Which is instinctively odd, given that it’s only whoever wins the 2nd round who actually counts. But this has occurred because the 1st round has become so unpredictable: 4 candidates now have a similar chance of making it through, with each polling around 20-25% [chart courtesy of @GoodwinMJ]:

The reasons for this convergence in the past month?
Firstly, Fillon staunched the bleeding. If you’re going to have a scandal come out, get it all out early. Secondly, Le Pen’s campaign has been lacklustre, with headlines stolen by the new kid on the block, Macron. And then finally, the joker in the pack: the far-left candidate Jean-Luc Melenchon has staged a last minute rally, throwing predictions for the winners of the 1st round up into the air. Why has he done so well? It would appear that some left-wing voters aren’t happy to sign up to pseudo-Blairite Macron’s bourgeois centrist platform. In effect, the Melenchon surge has occurred precisely because the market’s favourite, Monsieur Macron, has been doing so well. If you want to be complacent, you could say that if it’s a sign of Macron’s strength, then it’s even more likely he will win the whole thing: in other words, a sign that we really will get the market-friendly outcome.

So you check the polls again, relax, and sit back and wait to buy the dip.

CLANG!
There goes the first warning bell: we know the polls have been flawed in recent years. Across the world. And largely because we are now experiencing a significant redrawing of political landscapes as The People vent Their Frustration with The Man, what with that whole financial crisis/austerity/low wages/tech revolution thing going on. Polls frequently work by drawing conclusions off baseline scenarios. But what’s the baseline for now?

OK, you say, but in the absence of anything else, it’s the best we’ve got. And the polls give a quantitative number. You need numbers for probabilities. So, you run the polls for the 1stround, then poll people again given various 2nd round options…

CLANG!!
Second warning bell: So, the 1st round has become incredibly predictable, with each candidate polling at a similar level. How do we now re-distribute voters into the 2nd round? If left-wing voters are choosing Melenchon over Macron now, will they choose Macron in a 2ndround just two weeks later? Would Macron rank over Le Pen? Will they turn out to vote at all?

CLANG!!!
Third warning bell (goodness this is getting noisy): If the second round is indeed Marine Le Pen vs Emmanuel Macron that’s a party that’s never held much public office vs a party that’s never even existed. So how would you vote, Monsieur Socialiste? Ok maybe you’ll look at their policies. Here’s a nice wrap from Bloomberg Politics:

So does the alleged “right wing” Fillon voter turn to Macron in the 2nd round even though he wants to meet the EU’s deficit target? Or does that voter fear even more austerity, preferring to plump for the fiscal largesse of Marine?

If anything, the four-way split in the polls just goes to show how incredibly unpredictable this French election is. Two of those four candidates want to force a significant new relationship between France and the EU. That’s a 50% chance that we get someone in the second round who would be incredibly disruptive to European assets. That suggests a 25% chance we end up with that in the final round too. And in just four days’ time, that probability could double to 50% if Melenchon or Le Pen get through. Let’s not forget that Donald Trump was only polling at 36% on the actual day of the US election.

We may well believe that 25% is a risk we are happy to bet against. We may well believe that the forces of selling vol and earning carry will always continue to pay off. We may believe that reflationary momentum in the world economy is so strong that it doesn’t matter who runs France. After all, that’s been the lesson of the past 18 months, hasn’t it?

But couldn’t we also easily believe that a failure to deliver a “market friendly” candidate in an election in one of the founding members of the EU will cause a fundamental re-think of whether to hold European assets? And that the probability of that happening is not zero, nor 1 in 4, but potentially evens at 50-50?

Looks like we will need that pint on Sunday…