The Intertwined Risk Factors Of 2016

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Includes: DIA, IWM, QQQ, SPY
by: Ben Emons

Summary

Coming off a poor first quarter, financial markets gear up for a second half that could prove pivotal for direction going forward.

Six near term events can be categorized in three key effects: social-political (UK referendum, U.S. elections), economic (OPEC, IMF review) and financial (FOMC, G20).

Investors should be mindful of what's ahead and position portfolios with the right insurance and selective offensive bias.

Coming off a poor first quarter, financial markets gear up for a second half that could prove pivotal for direction going forward. There are currently three main risks that capture markets; liquidity, duration and credit risk. These risks are closely related to future events. Such events could be the following:

1. IMF Review Greece (April 11, July 20 ECB bond redemption)

2. OPEC meetings (April 17, June 3)

3. UK Referendum on exiting the European Union (June 23)

4. G20 meetings (April 13-14, June 22-23)

5. FOMC Meetings (April 27, June 15).

6. The U.S. Presidential Elections (November 9)

At face value, these are "standard" calendar events. Yet, in the context of today's markets the events are unique in several ways. For example, rolling crises in Greece since 2010 have been a source of repeated market volatility. The effect was global central banks engaging in quantitative easing ("QE"). The (infamous) OPEC meeting in November 2014 to keep output unchanged set the trend in oil prices to fall to new lows. This caused stress in credit markets and the financial system globally. The Federal Reserve embarking on tapering QE at their December 2013 meeting helped the dollar to reach super strength in 2015. These three combined factors--low oil, strong dollar and high volatility--resulted into repetitive chain reactions across markets, also known as "domino effects."

In financial markets and economies, domino effects are related to "cause and effect" whereas events cause a chain reaction as a result of something that was unexpected. And at the point of unexpected causality is when markets tend to overshoot. In January 2016, markets overshot on a financial domino effect caused by uncertainty about the European banking system' ability to pay their senior financial debt. The negative market reaction was reversed by the ECB's aggressive credit easing, OPEC's consideration of output reduction, and G20 "agreement" on currency depreciations.

As the market saw an impressive rebound since February 11, confidence grew among Fed members to tighten as early as April. Along the way, Chinese and global economic data remained soft, and the terrible events in Brussels reminded markets geo-political risks remain elevated. The mix of the three--Fed, China/global economy, Geo-Political risk--continues to fuel uncertainty. With that uncertainty in mind entering Q2 2016, markets may ponder which of the six listed events could be the next "domino?"

To answer that question, the six events can be categorized in three key effects: social-political (UK referendum, U.S. elections), economic (OPEC, IMF review) and financial (FOMC, G20). The likely biggest risk event is OPEC and the UK referendum because they could present an inflection point. A change in oil output could have an accelerated effect on inflation in developed markets. A Yes vote in the UK referendum could spark great uncertainty about the existence of the European Union, and may cause a recession in Europe. Adding to uncertainty is Greece with ECB bond redemptions due on April 11 and July 20 and worsening migrant crisis.

So which could be the real next domino? The answer is cause and effect. The series of events batched between April 11 and June 23 could resemble a toppling row of dominoes. If Greece fails to meet requirements by the IMF and its bailout commitment casts doubts, the Brexit debate in the UK could be fueled and sway polls to a Yes vote. This could pressure on Sterling and European assets. If OPEC Doha meeting on April 17 fails to present an agreement to move forward on how to stabilize oil prices, credit stress in the energy High Yield sector could quickly appear and may spill over to global equity markets. If G20 and the FOMC continue to convey a muddled message, markets may doubt the effectiveness of global monetary policy. Not one event is the single dominant domino. But clear is uncertainty about outcomes of listed events is going to take place in a narrow period of time (April 11 to June 23).

For investors this means "flight to quality" may roar its head quickly. For portfolios this implies two strategies:

  • Insurance: position defensively on negative domino effects
  • Policy action: position offensively on positive domino effects

Fed research (Wei, Beale (2014) has empirically shown during Flight to Quality episodes, bond excess returns outsize equity returns by 2.5% to 4%. At the same time, if the policy action is adequate, equity returns could outpace bond returns by 8 to 10%. For portfolio construction, the insurance should be centered on liquid government bonds which have the highest liquidity premium compared to cash. For offensive positioning, equity exposure is most sufficient through ETFs or index futures.

Markets will price scenarios (revolution, recession, financial crises) with different outcomes (war, default, inflation). Based on the six events taking place on the near term, some of the possible scenarios (potential recession in Europe) and outcomes (higher inflation) can set a new trend for markets into 2017. Investors should be mindful of what's ahead and position portfolios with the right insurance and selective offensive bias. That means maintain duration and a high level of liquidity, while adding credit risk where technical dislocate value from fundamentals.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.