Your Portfolio Needs The Status Quo: A New Franc, Bank Runs, And Political Upheaval

by: The Heisenberg


One bank takes a look at the risk of "Frexit" and doesn't like what it sees.

Is your portfoilio immune to a French default? Trust me: the answer is almost unequivocally "no".

Do you really want the world to become "fair"?

On Friday night, I penned a short piece called "Boiling Frogs."

The central point was that we, as investors and traders, are uniquely exposed to the hazards associated with the transatlantic political experiment playing out in the US and Europe.

To be sure, that's a pretty selfish way to look at things. That is, there are far reaching societal consequences associated with this same political experiment and those consequences are most assuredly more important than the investment implications in the broader context.

But this isn't the broader context. This is the investor/trader-centric context and so, we'll confine ourselves to a discussion of the market implications.

The reason I say we are "uniquely exposed" as investors and traders is that we have assets whose prices are directly affected by political outcomes. Our assets function as real time referendums on the likely economic consequences of geopolitics.

Of course, real time referendums are by definition subject to knee-jerk reactions and it's impossible to say what's a knee-jerk and what's not until years down the road.

That is, was the 600-point plunge and associated FX turmoil that followed the Brexit vote a "knee-jerk" reaction followed by a period of relative calm?

Or was the rampant optimism that drove stocks to new highs following Trump's election a "knee-jerk" reaction that will be followed by a period of relative turmoil?

Again, we won't know until years from now. If Brexit risk reasserts itself and drives markets lower as the economic reality of the UK's split with the EU sets in, then the post-Brexit vote reaction can't really be described as "knee-jerk" anymore. On the contrary, it will be the interim period of calm that's later seen as "knee-jerk-ish" (if you will).

Similarly, if Trump's growth-friendly reform measures underwhelm and are outweighed by the uncertainty his other policies engender, then it will be the post-election bounce that's viewed by history as a "knee-jerk."

Anyway, the point is that as investors and traders, we're vulnerable in a political experiment. We don't have the luxury of waiting to see how things pan out. Markets will render judgments on the fly, and the hit to our assets in an adverse scenario will be immediate (note: that doesn't mean we have to realize the losses, but on paper, they will be there until prices recover - if they recover).

Here's what I said previously about our collective situation:

Think about the difference between Brexit, Trump, and France. Brexit is going to take years to play out. Trump has certainly done a lot in his first few weeks when it comes to creating uncertainty and lord knows he's made some bombastic promises, but he hasn't threatened to default on $2 trillion in government debt.

What we're seeing in Le Pen's redenomination promise is a further pushing of the proverbial envelope. We got Brexit. Then we got Trump. Now we may get Le Pen and with her, a sovereign default the size of which no one can even begin to contemplate.

We, as investors, are left to sit by and watch as the stakes are continually raised in this transatlantic political experiment.

We're like boiling frogs.

Well, as it turns out, Citi agrees. In a note out Friday evening that I swear I hadn't read when I penned the passage cited above, the bank explains why a Le Pen victory in France "would be a much bigger deal than Brexit."

Here are some excerpts from Citi's note (my highlights):

Le Pen has stated that, if elected, she intends to take France out of the euro within six months (and hold a referendum on EU membership), with her spokesman confirming they would seek to redenominate the portion of the €2tn of public debt that is issued under French law (which is the vast majority). With the Front National also pledging to end central bank independence and considering monetary financing of public spending, it is hard to see a "new franc" being greeted with anything other than a significant depreciation.

From a market perspective a Frexit (or "Fr-euro-xit") scenario is very different to Brexit, which posed a two-way risk that could be traded in FX markets. As a oneway, asymmetric risk, which cannot ex ante be borne by the currency, redenomination must be reflected in the risk premium on the assets themselves.

A 20% ex-ante drop in market price to reflect a redenomination event would amount to a spread widening of about 250bp on a par 10-year bond, and about 450bp on a par 5-year bond.

However, such a risk-neutral calculation probability has little bearing on how spreads would actually react around a redenomination event. Other technicals would likely dominate. S&P, for instance, has stated it would regard redenomination as an event of default. Even if the bonds are still paying coupons in new francs, we suspect that many funds would be barred from holding defaulted bonds, creating the scope for considerable amounts of forced selling.

The most obvious of a number of potential initiatives would be the likelihood of capital controls in order to prevent a run on banks. Depositors faced with the same one-way risk as domestic bondholders would surely seek to move deposits outside of French jurisdiction.

Right. See what I'm saying about investors being boiling frogs?

What a lot of people don't seem to understand is that we're being continuously tested to see what our collective tolerance is for the implementation of bombastic campaign promises.

Well, we got the UK out of the EU, let's see if we can get Donald Trump elected in the US. Well, we got Donald Trump elected in the US, let's see if we can get Le Pen elected in France. Well, we got Le Pen elected, now let's see if we can push through the largest sovereign default in the history of the world (and no, that's not an exaggeration).

Think about the bolded passages above from Citi. Note the part about how French redenomination risk can't be shouldered by FX markets alone. This isn't as simple as Brexit. You're talking about the dissolution of the currency bloc, the introduction of a new franc, and the prospect of an immediate €1.7 trillion default.

Not to come across as condescending, but do you have any idea what the repercussions of that would be for asset managers the world over and for the global financial system in general?

As Citi puts it, in what I assume was an attempt to elicit a chuckle from clients by deliberately understating the case, "for the European banking sector as a whole, even with netting, margining, the move to central clearing and various regulator initiatives, the implications for swaps and other derivative markets of redenomination and capital controls are presumably rather large."

Yes, "presumably rather larger."

Like Godzilla-ish large.

If you were in these markets - and I mean actually in them trading - in the summer of 2015, you vividly remember the old "Greek weekends." For months, it was touch and go with regard to a Greek exit from the EU. And by "touch and go," I mean you had to monitor your positions constantly. The threat of a meltdown was ever present. Changes in the haircut on Greek banks' collateral in ECB emergency liquidity ops became as important as changes in US non-farm payrolls (no, seriously).

The problem - I think - is that when I say things like that, readers aren't visualizing it properly. I'm not talking about sitting at home and tracking the gyrations of a couple of SPY puts.

Home gamers have to understand that when things like say, a French redenomination event unfold, there are thousands upon thousands of people out there trying to keep your retirement portfolio from imploding as the entire financial universe de-risks simultaneously.

Creative destruction is a healthy thing. Indeed, I've consistently bemoaned the fact that wide open capital markets have served to create a legion of zombie US energy companies that wouldn't still be in business if investors had anywhere else to turn for yield.

That said, it's one thing to say that we should rethink central bank policy now that we're nearly a decade removed from the crisis. It's entirely another to implicitly (and sometimes explicitly) talk about deliberately disrupting or worse, systematically dismantling, institutional frameworks that underpin trillions upon trillions of global assets.

Note what I said above. When calamity comes calling, there are thousands upon thousands of people out there trying to keep your retirement portfolio from imploding as the entire financial universe de-risks simultaneously. Those people include the very same traders, "banksters" (to use a popular epithet), prop desks, central bankers, and bureaucrats that populist candidates swear need to be uprooted and thrown to the wolves.

And yes, those traders, "banksters," and bureaucrats are the very same people who have stuck it to the little guy on countless occasions over the years and at times have engaged in practices (think LIBOR rigging) that are outright illegal.

But you need to know the truth about your portfolio and how it's likely to perform should the political environment continue to shift in the direction it's currently shifting.

Put simply, you'd better hope that common sense prevails in what is clearly becoming a standoff between populist candidates and established institutions.

I'm going to leave you with an exceedingly apt quote from a film I reference quite often.

In the Wall Street drama Margin Call, an investment banker played by Paul Bettany explains to a junior analyst why the status quo is a good thing. Here is what he says:

If you want to do this with your life, you have to believe you're necessary and you are. People want to live like this with their cars and their big houses, then you're necessary. The only reason they all get to continue living like kings is because we've got our fingers on the scales in their favor. I take my hand off ... and then the whole world gets really fair, really quick and nobody actually wants that. They say they do, but they don't. They want what we have to give them, but they also want to play innocent and pretend like they have no idea where it comes from.

Think long and hard about that.

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.

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