Brace Yourselves, Volatility Draws Nigh, PIMCO Warns

One of the key themes I try to communicate to investors is that in the current environment, you simply can’t understand markets if you don’t understand geopolitics.

This has always been the case to a certain extent, but it’s arguably more true today than ever.

The Saudis, for instance, are wielding their sway over oil prices as a tool of foreign policy in the kingdom’s eternal sectarian feud with the Iranians. The ECB has variously conspired with Brussels to use the central bank’s QE and liquidity operations to dictate the fiscal policies of recalcitrant periphery governments. And then there’s China, where the necessity of maintaining a fundamentally unsustainable economic boom and thereby avoiding a crash that could lead to social unrest has forced the Politburo to devalue the yuan, sending shockwaves through global markets.

As noted above, geopolitics has always been important when it comes to markets, so why do international political events matter more now?

There are a number of answers to that question, but here’s one explanation from Jean Boivin, head of economic and markets research at the BlackRock Investment Institute:

“Geopolitics is front and center in how we think about the outlook and potential risks to the markets. We are in an environment where growth is fragile, uncertainty is elevated and there is a lot of focus on event risks that geopolitics can present.”

In other words, the post-crisis world has thus far been characterized by sluggish global growth and trade and it’s looking more and more like that may have become structural and endemic as opposed to cyclical and transitory. Ironically, central banks’ collective efforts to boost growth have embedded an enormous amount of risk across markets by making quality collateral scarce and by perpetuating an intractable currency war that at times wreaks havoc on FX markets.

Were all of that not the case (i.e. if the world were experiencing a truly robust economic recovery and if central banks hadn’t put everyone on edge by pushing monetary policy to its absolute limits), the market would probably be more resilient to geopolitical shocks.

But alas, here we are in a world where central bankers can’t even breathe wrong without triggering some kind of dramatic event and where developed markets are lucky to post 2% growth.

Recall what SocGen said about political black swans:

“With a very busy political agenda lined up for the coming quarters, the risk of an event delivering an unexpected outcome remains high, be it the OMT (outright monetary transactions) judgment from the German Constitutional Court on June 21, the U.K. 'Brexit' referendum on June 23, Spanish election on June 26, Italian referendum in October and heading into 2017, elections in France, Germany, Netherlands and possibly Italy.”

And here’s a slide from a recent Citi macro deck wherein the bank asks the following question: “Political Risk: Is This The Start Of The Breakdown?”

(Graphic: Citi)

“Breakdown” may be too strong of a word, but there’s certainly no question that things are becoming exceedingly precarious.

It’s with all of that in mind that PIMCO is out warning investors that “uncertain politics and policies” have the potential to shakeup FX markets over the next few weeks.

“We need to be respectful of the technical uncertainty associated with central-bank policies and increasingly volatile and uncertain politics,” Daniel Ivascyn, group chief investment officer at Pimco told Bloomberg, who notes that “a gauge of implied global foreign-exchange volatility jumped by the most in four months this week as traders cut the odds of an interest-rate increase by the Fed at its June 15 meeting.”

As we’ve seen and discussed, equities traders must be cognizant of what’s happening in FX markets. Dollar up equals oil and risk down. Yen up equals stock selloff. And so on.

It’s all part of the same underlying narrative: you can’t afford to just be an equities trader. You have to take a completely holistic approach and that means factoring in geopolitics, FX, commodities, and everything in between.
Be careful out there.