By Bluford Putnam and Erik Norland
Political risk is rising - elections in Mexico, Brazil and the U.S.; a leadership battle for Japan's ruling Liberal Democratic Party (NYSE:LDP); the U.S. planning protectionist trade tariffs against China, the European Union, Canada and Mexico; a looming Brexit deadline and shifting OPEC and Russian oil production tactics, among other risks. Dates for the elections, Brexit and OPEC are known but not their outcomes, which have very different scenarios. The U.S.-initiated trade disputes ebb and flow, yet the different scenarios could move equity markets.
With rising political event risk comes an elevated risk for sudden price moves in markets that are in the spotlight. The challenge for risk managers is that two very different, often polar-opposite, scenarios will be debated. But when the event happens, such as an election, the outcome becomes immediately known and prices move quickly to reflect the prevailing scenario. We have seen this in equities with the trade war rhetoric. When the U.S. threatens to impose tariffs, equities can swoon, only to recover as tensions ease. With several of the upcoming elections, such as in Mexico and Brazil, it is the currency markets that will react sharply to the outcomes. And, in several cases involving trade, U.S. agriculture will be the target for tariff retaliation.
Options can be a very useful tool for event risk management. One must remember, however, that calculations of implied volatility usually do not account for price gap risk (e.g., if they are based on a straightforward Black-Scholes model). So, the calculated implied volatility may include a premium for price gap risk on top of any expected shift in the volatility regime. When the event date is known, then one may also study the differences in options prices and implied volatility calculations for options expiring before and after the event date to help ascertain how much event risk is present in a given market.
Here is our quick review of the event risk possibilities over the coming six to nine months
The Mexican Presidential election is on July 1, 2018. The former Mayor of Mexico City, Andrés Manuel López Obrador, is the front-runner. He is focused on income inequality and government corruption. All the candidates are uniformly anti-U.S. The U.S. will probably announce its withdrawal from NAFTA before the Mexican election or shortly thereafter. Canada has also made clear that it will not be bullied by the U.S over NAFTA. The Mexican peso is in the spotlight and is vulnerable. Corn and live cattle prices could fall if NAFTA is abandoned. Mexico has also targeted live hogs for trade retaliation, with an immediate impact on market prices.
Brazil elects a new president in a two-round affair on October 7 and 28 (assuming no one gets 50%+ in round one). Over a dozen candidates are running - legislators, former cabinet officials and a Supreme Court Judge; and the candidate leading in opinion polls is an impeached President running from prison. It is way too early to call this election, but the Brazilian currency is already reflecting the risks.
The U.S. Congressional elections are on November 6, 2018. The Democrats have a credible shot of retaking control of the House of Representatives. If you think U.S. politics is polarizing now, just wait for 2019, if the House goes Democratic and the Senate stays Republican. U.S. equities and bonds will be in the spotlight on election night.
Japan's Prime Minister, Shinzō Abe, won a decisive parliamentary victory in 2017, but he is not popular in his own party. The Liberal Democratic Party will hold its congress in September to elect a new leader, who will become the Prime Minister. Abe wants to push for remilitarization of Japan, and he would also like to be the Prime Minister on July 24, 2020, to open the summer Olympics in Japan. More Japanese yen volatility may be on the way, especially if a new leader were to review Bank of Japan policies.
Turkey has general elections on June 24 (first round) and July 8 (second round). President Recep Tayyip Erdogan advanced the elections, which were originally scheduled for November 2019, probably figuring that they would be an easy win for his People's Alliance (AK) Party. However, AK's lead has been falling, and the recent currency crisis probably is not helping matters. The Turkish Central Bank raised interest rates from 13% to 16.5% to defend the currency and contain inflation - an unpopular move with Turkey's small businesses, many of which depend on bank financing. Import prices are also rising sharply, taking a bite out of real consumer incomes and spending. Turkey plays a key role on the regional balance of power, including in the Syrian conflict.
Trade wars can erupt and calm down at a moment's notice. Each country's leader is always speaking to their own citizens, which can get confusing if you think they are "negotiating" with the U.S. Taking strong public anti-U.S. positions is often a road to domestic popularity, while still discreetly negotiating behind the scenes.
Equities tend to react negatively to trade war eruptions, but the impacts are much more company or product specific than they are likely to damage economic activity. Economists, including ourselves, often roll out a reminder of the Smoot-Hawley tariffs of 1930 and the Great Depression. In reality, the impact of a trade war on the U.S. and global economy will be relatively small; however, there will be lots of company or product winners and losers, which is why equities are in the spotlight. Indeed, China and Europe appear to have settled on a strategy of retaliating with tariffs designed to inflict political pain on Republicans in the U.S., while limiting the economic damage at home. Agriculture is an obvious target. Watch soybeans if U.S.-China relations deteriorate. Watch live hogs, live cattle and corn in the case of Mexico and NAFTA. A U.S. withdrawal from NAFTA will also hit automobile companies and their suppliers. Automobiles are a poster child for complex, multi-country supply chains.
The Brexit deadline is March 29, 2019, when Britain's membership of the EU will lapse, and it is getting closer every day. No solutions to the vexing Irish challenges are in sight. The UK may miss the deadline or Prime Minister May could face a leadership challenge, and even new elections are possible. The EU's lead negotiator recent told May's government to "quit playing hide-and-seek" and to come up with clear positions on key issues. Watch the pound and the euro, already weakened by the Italian and Spanish leadership issues.
Italy and Spain
Spain: The center-right Partido Popular's (PP) Mariano Rajoy is out as Spanish Prime Minister after seven years in power. What is interesting is that Spain did not just switch Prime Ministers, it switched governments without holding another election. His replacement, Socialist (PSOE) Pedro Sanchez, is governing with the help of Catalan pro-independence parties and the far-left Podemos. This fragile coalition may lead to new elections well before 2020, when the government's term is scheduled to expire. At the very least, the Spanish government will be a weak partner for French President Emmanuel Macron as he seeks deeper European integration.
Italy: In the end, the far-right Northern League and the populist Five Star Movement are forming a government after being told by Italy's President that they could not do so last week. Will their leadership be a tax-cutting, big-spending budget buster that Europe's fiscal hawks and the Italian bond market fear? Or did the bond market's near-collapse set them on a more disciplined fiscal course? For the moment it's hard to say, but the Italian bond market's big bounce off the lows might prove short-lived. Markets have a way to retesting and sometimes breaking lows following big sell-offs.
OPEC and Oil
The next OPEC meeting is on June 24 at its headquarters in Vienna. Russia and Saudi Arabia appear to have cut a deal to increase production and take advantage of high prices. U.S. shale production is expanding but also overwhelming pipelines, meaning that U.S. export growth may not calm markets until 2019.
In addition to OPEC, oil's other event risks fall into two primary categories: conflict between nations and conflict within nations. With respect to the former, the U.S. rejection of the Iran nuclear agreement risks intensifying the regional rivalry between Saudi Arabia and Iran, which are already fighting proxy wars in Yemen and Syria. Elsewhere, one year on, the dispute between Qatar and Saudi Arabia is intensifying as well. Qatar is cracking down on imports from Saudi Arabia and the UAE. U.S. recognition of Jerusalem as Israel's capital and the subsequent Palestinian reaction also adds to the regional uncertainty.
The biggest risks to oil prices may come from problems within oil producers rather than between nations. Saudi Arabia has launched another crackdown on dissidents. Its war in Yemen is deeply unpopular at home. It is trying to mollify religious conservatives upset over the decision allowing women to drive and the introduction of movie theaters by cracking down on pro-reform dissenters.
Venezuela continues to sink deeper into economic chaos. Despite its proximity to the U.S., any disruption of Venezuelan oil supplies could impact Brent more than WTI. Venezuela produces a highly sulfurous crude that is more like North Sea crudes than light sweet crudes from Texas.
Egypt's government is becoming increasingly repressive as the country's economic situation deteriorates. Although Egypt is not a major oil producer, its control over the Suez Canal is crucial to global trade in general and the oil in particular. Moreover, Egypt exerts enormous cultural influence within the region, and any instability in the country would be most unwelcome in Saudi Arabia.
As an addendum to their widely publicized trade disputes, the U.S. and China are also ramping up the rhetoric over the Chinese establishing military installations on artificial islands built in the South China Sea. These islands have important implications for fishing, oil and natural gas exploration and control of shipping. The U.S. has warned China that there will be consequences for building military installations on those islands without (yet) detailing what those consequences might be.