Column-Political risk aversion rubs its eyes: Mike Dolan

06/28/2024

4 minutes read

2024.06.28 02:13

By Mike Dolan

LONDON (Reuters) – If greater political uncertainty necessarily begets higher financial volatility, world markets are still half asleep – but the alarm clock may be set nonetheless.

With a blizzard of political risks on the horizon, financial markets seem reluctant to second-guess hard outcomes – or material impacts on the economic, fiscal or corporate worlds that might be affected by changes of government and voter swings.

With this week’s first televised U.S. presidential debate sounding the starting gun for many for November’s election race and French and British parliamentary polls hoving into view next week, a year of elections worldwide is reaching a crescendo.

Each one has its own domestic saga and international policy implications, none more than the U.S. contest.

But fear of change doesn’t necessarily make for a great investment play when trying to parse the outcomes.

For all the potential sharp edges and tensions in all three, there are few one-way macro market bets – not least as dominant themes of central bank policies and artificial intelligence-led tech booms cut across so many anxieties.

Fiscal incontinence and debt sustainability issues are the clearly most cited worry. And government bond yields and implied volatility levels are indeed historically elevated – though mostly well below levels of the past two years of inflation spikes and interest rate rises.

Wobbling French debt and equity have shown most sensitivity this month to the snap election – though how much that’s down to the surprise as much as likely outcomes remains to be seen. British stocks are marginally off record highs too.

And yet the euro and pound have barely flinched on the foreign exchanges – softening only mildly as poll dates approach.

Wall Street and world stocks remain near all time peaks and the ‘fear index’ of implied volatility, as well as the higher VIX futures out to the end of the year, are all but comatose relative to recent ructions around the pandemic and its aftermath – or even around the last contentious election.

A puzzle or waiting game?

If you can’t be sure yet of the poll outcomes or indeed what political winners will actually do rather than what they now promise, then there’s danger in jumping the gun in an otherwise relatively benign economic backdrop.

And while Britain’s result may seem a dead cert, French and U.S. results remain in the balance.

Neither the far right nor far left in France are estimated to gain outright majorities, and would probably have to exist in a messy ‘cohabitation’ with centrist President Emmanuel Macron for the next three years anyway even if they did.

U.S. President Joe Biden is still neck and neck with challenger Donald Trump in the White House race, meantime, and even if Trump returns, most investors see many of his sharper policy edges sanded down by likely gridlock in Congress.

JUMP THE GUN

Societe Generale (OTC:)’s equity derivatives strategists Jitesh Kumar and Vincent Cassot think the elections – and perhaps the actual performance of any new governments – may ultimately provide a trigger to finally hedge heady equities.

Just not yet.

They think that’s a story into 2025 rather than now, not least as they see the politics being more a catalyst for a shift that will be overdue anyhow on flagging growth momentum and still-lagged hits from higher interest rates.

“Our models point to a substantial rise in volatility, and over a fairly short period of time,” they told clients, pointing to the year-end period for the big shift even if political risks seem already hard to ignore.

“While political uncertainty very rarely changes the broader volatility backdrop, it can act as a trigger or catalyst for an expected change in volatility regime.”

For currency markets primarily in thrall to shifting rate differentials and central banks, the picture is more complicated – not least as an already pumped up dollar may well stand to gain further from wider market nerves, threats of tariff wars or geopolitical stress.

Not unlike subdued equity seismographs, most measures of currency volatility are similarly under wraps at levels less than half those seen during the race to tighten interest rates and amid the UK bond shock of late 2022.

They have ticked higher lately around elections in Mexico and India and, notably, the euro hiccup on the French surprise – even if the gauges remain low by historical standards.

Barclays FX strategist Themos Fiotakis and team sketch out a more nuanced view of how to tread on the political minefield alongside the shifting interest rates – modeling how markets match up rate gaps, or ‘carry’, with options market bias for puts or calls on a currency, so-called ‘risk reversals.’

Carry and risk reversals are typically negatively correlated, in that the bigger the interest rate risk premium on a currency, the bigger the implied crash – a factor making sometimes lucrative ‘carry trades’ inherently risky.

Judged on modelling this relationship, Fiotakis points out that the market’s appetite for downside protection on many currencies has increased and its signal on risk aversion amounts to the most since 2020.

“Risk tolerance has decreased considerably in FX markets lately in the wake of the various election surprises,” he wrote, including emerging market ructions along with the majors.

But he added: “The market being, on aggregate, more aware of political risks does not mean that it accurately prices those across all currency pairs.”

Crunching his model, the conclusion was that higher levels of risk aversion toward the euro and Japan’s yen, already ailing at 38-year lows, was easily justified.

But similar levels for Switzerland’s franc may be mis-priced due to its traditional haven role around euro zone political ructions.

On the flipside, the Barclays team reckoned only a modest positive bias toward the pound in pricing may understate the market’s possible reaction to better post-Brexit UK relations with the European Union under a Labour Party government.

And they felt that possible tariff threats ahead, property sector worries and competitive pressures from a weak yen meant the relatively sanguine reading on may well warrant protection.