In today’s world you never, ever, want to underestimate geopolitical headwinds when it comes to investing and trading.
The more interconnected and interdependent markets become and the faster news travels between participants in those markets, the more likely it is that events in far-flung locales will have an outsized impact at home, wherever home happens to be for you.
Brexit was a case in point. If you had to come up with a euphemism for “horribly boring” you might well choose “British politics.” But that all changed on June 24 when the UK electorate unexpectedly (and possibly without the proper amount of reflection) voted to leave the European Union.
“Big deal, markets quickly recovered,” you might fairly say. Yes they did, but don’t forget what happened on Brexit Friday - and I don’t mean the stock sell-off. S&P 1-month VIX futs had their largest one-day return in recorded history and the British pound saw a 13-sigma move which, statistically speaking, is impossible.
Well, on Friday night we got the latest geopolitical black swan when a faction within the Turkish military attempted to overthrow the government of President Recep Tayyip Erdogan. This is what happened next:
That’s the largest move for the lira in eight years and as you can see, US equity futures took a dive almost immediately.
It’s worth taking a pause to discuss why this matters. This isn’t some Third World back alley of no consequence. This is Turkey. A NATO member and, critically, the corridor through which Mid-East refugees fleeing war-torn Syria, Afghanistan, and Iraq pass on their long and arduous journey to Western Europe. What happens in Turkey matters. A lot.
For those not well versed in Turkish politics, President Erdogan is determined to alter the country’s constitution in order to consolidate more power in the presidency. This is a long-running effort that culminated this year in the removal of former Prime Minister Ahmet Davutoglu and a worse-than-usual crackdown on media outlets deemed critical of the government. NATO is obliged to back the Turkish government, a position that’s become increasingly untenable since Ankara downed a Russian fighter jet on the Syrian border last November.
There’s also a civil war going on in the country’s southeast, where government forces are battling remnants of the PKK, a Kurdish militant group considered “terrorists” by Ankara and Washington.
Since last summer, Erdogan has allowed the US to fly anti-ISIS missions from Turkey’s Incirlik, air base, but the effort has been hampered by persistent rumors that the Erdogan administration tacitly supports Islamic State and other Sunni militant organizations in their bid to overthrow the Assad government in Syria. Russia has formally accused Erdogan and his family of backing ISIS.
So you can begin to see why this is a big deal.
The issue for markets is the degree of complacency against which such a volatile geopolitical backdrop is cast. Here are some bullet points from Goldman which describe just how calm the waters are out there:
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The VIX landed at 12.8 on Thursday, 7/14, dropping below 13 for the first time in 2016.
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The VIX has closed lower only 5% of the time over the last year, 15% of the time relative to its full history back to 1990.
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July VIX futures are trading at 14, down from 23.7 on June 27.
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Given the collapse in vol, how have short vol strategies faired? One way to analyze short volatility trades is to look at the performance of short VIX futures strategies.
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VIX ETPs like the XIV and the SVIXY are benchmarked to the S&P 500 VIX Short-Term Futures Daily Inverse Index (SPVXSPI). This index replicates a short 1m VIX futures strategy (inverse VXX).
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Bottom Line: Since the S&P 500 low on June 27, the short 1m VIX futures index is up over 48%.
Put simply, there’s zero caution. This market is priced to absolute perfection:
Turkey has put down the coup and there are some suggestions that Erdogan might actually have staged the whole thing to give himself an excuse to eliminate whatever vestiges of resistance are still around in Ankara.
Still we, as investors and traders, have to remain cognizant of geopolitical tail risks. Especially when they emanate from the most volatile region on the face of the planet and we’re priced as if the word “volatile” has been permanently banished from the financial lexicon.
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