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:
- Ok so those political event risks last year caused some wobbles; thank god all of them are out of the way now
- 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
- 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
- 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:
- Wait, are these guys making decisions that might actually affect the price of assets?
- So the valuation of everything I own is based on a shifting landscape that I can’t quantify?
- ……*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??