Gray Swans And Populism: Navigating A World Gone Mad

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About: SPDR Dow Jones Industrial Average ETF (DIA), SPY, SPYB, SPYD, SPYG, SPYV, IWM, QQQ, Includes: EEM
by: The Heisenberg
Summary

Has the world waded knee deep into a dangerous brand of populism with the potential to destroy much of what globalization has built over the past six or so decades?

How long until the disconnect between policy uncertainty and vol corrects itself?

What are 2017's gray swans?

This isn't sour grapes with regard to Trump's surprise win in the race for the Oval Office: I simply can't figure out why the brazen billionaire's unlikely victory is being treated as a reason to celebrate by backing up the proverbial truck when it comes to US equities (NYSEARCA:SPY).

It is by no means clear how this is ultimately going to play out and the assumption that Trump tax breaks and the repatriation of profits held offshore is going to bolster stocks by encouraging more buybacks and dividends seems a bit presumptuous at such an early stage in the game. Earlier on Thursday I took a look at some of the forecasts for the S&P and for the market in general and I've got to tell you, there's too much going on here to simply adopt the premise that Trump is good and that the anti-establishment line being promoted by the so-called "alt-right" is unequivocally good both for the EU and the US.

Remember, this could all still be a disaster in the making. Just because the world didn't end after Brexit, Trump, and the Italian referendum, that doesn't mean we're not headed in decisively the wrong direction here. We've got a politically unstable Europe that's one Russian/Iranian-backed Aleppo offensive away from experiencing a fresh refugee crisis and an American public some 48% of which is simply beside itself at the reality of Donald Trump becoming the leader of the free world for a period of (at least) four years.

For those who missed it, an article on PropOrNot purported to list some 200 Russian influenced websites that conspired to distribute agitprop during the lead-up to the US election in an attempt to influence the results. This report was cited by the Washington Post and despite those who will try to tell you it's a desperate attempt by the mainstream media to preserve some semblance of relevance in a world that's passed it by, I've got news for you: everything in that report is accurate - don't ask me how, but I'm absolutely sure of it. America, by electing a man whose campaign CEO is Stephen Bannon, chief of the bigoted, bombastic "news" platform Breitbart (which you'll find cited by any number of the sites mentioned by PropOrNot), has stepped knee deep into a dangerous brand of populism on the excuse that the status quo - as represented by the Clinton Foundation (a charity) - has become a kind of organized criminal organization worthy of a Martin Scorsese film.

There's every reason to be concerned about this shift. It's a shift away from the intellectual, away from the progressive and towards propaganda rooted in what amounts to a white supremacist ideology and which - purposefully or by happenstance - lends credence to a resurgent Russia and to an ideology that lumps all Muslims together under a banner of radical Islamic terrorism. What does this have to do with the market you ask? Everything. Have a look at this, out from JPMorgan's quant wizard today:

(Charts: JP Morgan)

As you can see, the market is becoming increasingly numb to what should probably be major shocks to risk. We've gone from a 65-day hangover following the August 2015 sell-off to a 9-hour pause after the Italian referendum. "It appears that the time horizon of macro traders has shortened, likely as a result of increased participation of machines and algorithms that are quicker to adjust to significant events and can eliminate trading activity of slower investors," JPM writes. Maybe. Or maybe investors just don't care anymore. Maybe they actually believe that none of this stuff matters - that the term "black swan" has become an anachronism. Just take a look at political uncertainty versus volatility for further evidence:

(Chart: JPMorgan)

And here's SocGen's resident doomsayer Albert Edwards citing politicaluncertainty.com:

Guy writes There are lots of reasons for caution, but the biggest is political uncertainty. Political uncertainty is a notoriously intractable concept, yet three brave academics in the US called Baker, Bloom and Davis (NYSE:BBD) do put a number on it in a website called politicaluncertainty.com. The real worry is that right now, BBD think that the world is even more uncertain than it was in 2008 or 2012. As the blue line in the chart below shows, their global economic policy uncertainty (NYSEARCA:EPU) index peaked at 201 and 218 in the last two periods of panic. It is now at 282! In 2008 and 2011, the correlation between economic policy uncertainty and credit spreads was very close. As uncertainty rose, so did spreads but something different is happening now. The EPU index is up at all-time highs, but spreads are at the median levels of the period going back to 2008. The chart implies that given the current level of economic policy uncertainty, global spreads should be twice as wide. This ought to worry the bulls. Actually it should worry everybody. On our analysis, US credit and corporate debt is the vortex of debility for the next recession.

Andrew Lapthorne and I have been banging the drum regarding the excesses in the US credit markets. It is not just the levels of political uncertainty that suggest corporate yields should be considerably above current levels. Normally at this level of corporate debt accumulation, investors have begun throwing their toys out of the pram (see chart below).

The above chart shows the absolute level of US junk bond yields. But even if we look at spreads, corporate bond yields are incredibly tight historically (see chart below). Strange!

It's literally hard to fathom. The divergence that is. And it's almost as if the alt-right both at home and abroad doesn't see itself as the proximate cause here. This isn't natural and it won't last forever. For their part, JPMorgan thinks the removal of policy accommodation could spell the beginning of the end. That is, what allows this anomalous relationship to persist is accommodative monetary policy and as soon as that rug is yanked out from beneath everyone's feet, the relationship between policy uncertainty and vol will reassert itself. That's certainly possible, but I'd argue that more likely is some manner of disaster at the political level. Say what you will, but you just can't have a United States and Europe controlled entirely by right-leaning reactionaries hell bent on righting what they perceive as the world's wrongs, which have variously grown out of globalization and can only be "corrected" by a healthy dose of intense nationalism.

For their part, Nomura is out with a list of possible "gray swans" that could shake markets in 2017. One of the concerns the bank mentions is an increasingly aggressive Russia. Here's how Bloomberg summed it up:

A staple of gray swan lists since Vladimir Putin's annexation of Crimea two years ago, Russian military aggression in eastern Europe remains one of the big risks for 2017. While an actual military invasion is unlikely, the foundations may be laid next year through anything from changes to U.S. foreign policy to the election of populist leaders in Europe, according to Nomura. Position for risk by going long credit-default swaps of any of the Baltic nations, shorting credit and trading Poland as a negative proxy.

This is exactly the kind of thing that the alternative media would have you believe is nothing more than Russophobia expressed through Western officials and media outlets, but let's face it: no one told Moscow to annex Crimea and no one told the Kremlin to invade Ukraine. The Stephen Bannons and RTs of the world can sit around and accuse the West of casting Moscow in a bad light all they want but they did what they did and anyone with any sense knows there's a chance Russia invades one or more of the Baltic countries and uses some kind of "trumped up" (no pun intended) version of manifest destiny to justify it. That's not Hillary Clinton's fault and it's not George Soros' fault either. It's Russian aggression, plain and simple and anyone who tells you otherwise probably has an incentive to push the pro-Kremlin agenda that's resonated so well over the past 12 months as a generalized disaffection with the mainstream Western media has grown. Here's another "gray swan" from Nomura:

Emerging markets may face "pronounced outflows" in 2017 if Trump's planned stimulus spending sends U.S. yields higher and further strengthens the dollar. That could prompt policy makers to take action, and they might even coordinate in a collective rebellion against the U.S. Countries most at risk are those with volatile currencies, low currency reserves and relatively low rates.

This is a reality the Fed has been trying to avoid for years. Indeed, the feasibility of an EM (NYSEARCA:EEM) meltdown can partly explain why the Fed overtly acknowledged international financial markets' role in its reaction function in August of 2015. Here's what JPMorgan has to say:

The underperformance of EM equities relative to the S&P 500 during November amounted to a highly unlikely ~3 standard deviation move. Historically, these moves were virtually always followed by a sharp correction (outperformance of EM over DM of ~5-10%). Furthermore, it is not unreasonable to expect a longer lasting reversion of the move since 2013 (Figure 3).

Ok fine, but if Trump has his way in terms of UST yields and the performance of the USD, the divergence shown in the chart above just might stretch to further extremes.

One final worry about 2017 is that central banks, in an effort to create counter cyclical room where there is none, will move to eliminate cash. I've been over this before, but the thing you need to understand is that when there's no more cash, there's no longer a lower limit on rates. If you want people to spend and those people do not have the option to hide in physical cash, banks can simply make rates so punitive that it doesn't make sense not to spend and thereby juice the economy. If it costs you 10% of your savings to keep your money in the bank, then by God you're going to spend. It's the only way to preserve value in the absence of physical cash. In this way, central banks can do away with the lower bound by doing away with physical banknotes. Here's Bloomberg recounting Nomura:

It seems inevitable that electronic payments will replace notes and coins at some point, but Nomura picks up on one reason why it might happen sooner rather than later: negative yields. Electronic money would prevent potential savers stashing money under their mattresses to avoid sub-zero interest rates. The risk to this scenario is of course that savers get hurt and consumers start inventing new hard currencies.

So there you have it. A snapshot of what's ahead. I for one suggest you pay attention. The world is a dangerous place and at some point, asset prices are going to start reflecting that reality anew.

We've made some bad decisions - but like Heisenberg walking around for a month with a bad pancreas, we just don't seem to realize it yet.

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.