Last month, in a brilliant presentation, Citi’s Matt King outlined “the polarization principle” and how it relates to politics, the economy, and markets.
The idea is that as interconnectedness and correlations increase, heterogeneity naturally decreases. When that happens, the incidence of extreme outcomes in politics, society, and markets goes up. Here’s how the bank depicted this dynamic:
(Graphic: Citi)
Needless to say, there are myriad factors at play both from a policy perspective and from a political perspective that have the potential to create quite a bit of havoc in today’s illiquid capital markets.
There are foreign wars. There’s geopolitical upheaval that is helping to keep the oil market in a perpetual state of turmoil. There’s the re-emergence of intense nationalism across Europe in response to the refugee crisis. And speaking of nationalism, there’s the meteoric rise of Donald Trump who in the space of 11 short months has managed to transform himself from reality TV star to the GOP nominee for the White House.
Last month, we described how one bank thinks you should trade the US presidential election. For their part, Goldman likes consumer staples and health care as likely outperformers when uncertainty picks up heading into November.
The bank also noted that no matter who wins, there’s likely to be a meaningful shift it America’s trade policy and for that reason, “stocks with high US sales will outperform firms with foreign sales,” Goldman reckons. Incidentally, US consumers might just be willing to help out along those lines. As we saw earlier today, Americans are increasingly choosing to buy at home despite the fact that as the Fed gets more hawkish, the more foreign goods consumers’ dollars can buy.
Speaking of the dollar, we’ve talked a lot lately about the strong USD’s potential to derail risk assets. We’ve also discussed how, if history is any guide, uncertainty is likely to increase sharply as the election draws near.
With all of this in mind, it’s interesting to note that amid all of the Fedspeak, no one seems to be pricing the inherent risks to to the dollar the way the market is pricing pound risk around the Brexit referendum. Here’s how Credit Suisse puts it:
“Hillary Clinton is still viewed as the most likely winner, but Trump is gaining ground. The USD vol curve is not pricing in any risk premium around the time of the election. Six months ahead of the Brexit referendum, the GBP vol curve was already steeper, and steepened massively in subsequent months.”
(Charts: Credit Suisse)
The bank continues:
“The USD has benefited in recent years from a surge in private inflows via the FDI and portfolio channels. An increase in uncertainty about economic policy ahead of the election could cause slow down in flows or trigger a reversal. We think this is a key downside risk to the US
D.”
(Charts: Credit Suisse)
This is a rather interesting dynamic. Here we are headed into at least one and perhaps two Fed hikes, which by all accounts will create an even larger disparity between US policy and that which prevails in Europe and Japan but if Credit Suisse is correct, we may just see offsetting flows as vol starts to spike.
Traders should probably begin to consider what this could mean sooner rather than later because as you can see from the right pane in the second set of charts shown above, this has the potential to escalate very quickly.
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