Equity markets have paused their ascent ahead of a number of key risk events and investors are becoming increasingly cautious about a potential resurgence of uncertainties given the recent highs in complacency and sanguine approach to risks.
A crucial YouGov poll, the only poll that correctly called the hung parliament in 2017, released this morning saw sharp moves in GBP/USD falling form an 8 month high as it looks like the Tory lead is narrowing. The poll outlined the Conservative majority shrinking from 68 at the end of November to just 28 and the margin of error in the poll also means that YouGov cannot rule out a hung Parliament.
For an outright Conservative majority in the House of Commons, they need to win at least 326 seats out of the 650 up for the vote. However, they can sometimes get away with fewer seats, depending on how other parties perform. The risks remain high in either direction for the currency and if the current trend in estimated seats continues, the Conservative majority could narrow further, meaning downside risks are on the up. At the end of the day results are decided in marginal constituencies where a small swing makes all the difference so the possibility for surprises is substantial. For more detail our Head of FX Strategy, John Hardy, has a great overview.
GBPUSD 1-week risk reversals which look at the the difference between put call 1-week implied volatility have shot higher (more negative, now -4.2) in a bid to hedge against the unexpected. Implying that traders are paying a premium for puts as put volatility is higher than call volatility. The market is becoming more worried about the negative impact on the currency should a hung parliament ensue, particularly given traders have been caught out before by the surprise result of the referendum and the 2017 election. A hung parliament would leave the country in a bind as it relates to Brexit, with uncertainty surrounding any coalition government a negative for the currency.
Risk took another hit as trade headlines from US President Trump’s Trade Advisor Peter Navarro crossed the wires. Navarro a notable hawk within the US administration said he has no indication that December 15 tariffs will not go ahead. But E-minis recovered in a hot minute as few were surprised by his stance given his notoriety as a prominent China hawk.
More conflicting headlines continued to baffle traders as a Wall Street Journal article detailed President Trump has not yet decided on December 15 China tariffs. At this point it is hard to have a high conviction view that doesn’t underestimate risks completely. Late stage brinkmanship is likely to be a factor and it makes sense to continue applying pressure up to the December 15 deadline. On that basis the most likely outcome and certainly the base case for market pricing, seems like another almighty can kick, as the US administration cites continued progress as a face saving way to delay the December tariff hike.
The key hold up is likely China’s insistence in rolling back tariffs as part of the phase 1 deal. The US administration are reluctant to rollback tariffs merely in exchange for agricultural purchases and currency pledges which may not even be followed through given China’s history of making commitments and failing to keep them, hence enforcement is the issue for the US side.
But the inability to agree on even the most low hanging fruit that amounts to little more than agricultural purchases and some concessions on currency and IP reform which are anyway in China’s best interest is concerning and only serves as further evidence of the chasm between the two sides. The Phase 1 deal IF reached is at best just short term truce, while both sides continue to increase self-reliance and relocate supply chains. The relationship has suffered permanent damage and hostilities may ebb and flow, but will remain for years to come.
Both risk assets and safe havens appear to have priced a base case delay in the December 15th tariffs, but price action is likely to remain subdued ahead of this weekend’s deadline.
What is certainly not priced is the potential breakdown of talks with the fresh round of tariffs imposed and this would be a huge readjustment to consensus. Particularly as valuations are stretched as earnings have deteriorated with upwards moves fuelled by trade hope, multiple expansion and accommodative policy not economic realities. If the tariff hike goes through on the 15th and negotiations break down once more, a correction across equities of 7-10% is by no means out of the question given the amount of positivity priced into markets, particularly once you factor in the year-end lull in liquidity. Although any Q4 2018 style meltdown would likely be avoided as we are dealing with a different Fed and suite of central banks across the globe who remain in easing mode, rate hikes are no longer on the table and they have already kowtowed to the markets liquidity demands. And the fact that yields around the world will remain low means we continue to see corrective moves being bought as investors sitting on the sidelines with dry powder step in when valuations correct. One lesson learnt from QE infinity and excessively accommodative monetary policy; asset price inflation. Notwithstanding, markets have managed to power some 20 odd percent higher on the same headlines for 12 months. If tensions flare up again, once common ground is regained US officials can surely find a way to spin doctor the next leg of negotiations for a few months.
The muted moves in equity markets portray a false sense of calm but beneath the surface measures of tail risk pricing have shot up substantially. The VIX is up above 15 again whilst net CBOE VIX shorts remain close to highs, which could make for some exaggerated price movements if volatility breaks higher. Traders are paying up for tail risk protection and SKEW is at a 1 year high as the expectation of a big move has risen and downside put buying activity has intensified. Being more cautious into year end makes sense given havens and equities alike have returned in double digits year to date.