Summary

“Political work is the life blood of all economic work,” Chairman Mao once said.

Well in 2017, “political work” may end up spilling the “life blood” of your portfolio.

How in tune are you to what’s really going on in geopolitics?

Mao Zedong linked politics to economics, but lately the tie between politics and markets might make him see red.

That’s from a Wells Fargo note out earlier this month.

There are all kinds of fun “red” puns in there, but the salient question for investors is this: will politics will make your portfolio “see red” in the year ahead?

As the Heisenberg crowd is acutely aware, my answer to that question is “yes.”

Well, actually my answer is “probably.” There are no certainties, a fact that seems to drive some readers to the edge of insanity.

Sorry, but I can’t tell you where the S&P (NYSEARCA:SPY) is going to end up in December. Just like I can’t tell you where the 10Y (NYSEARCA:TLT) is going to be six months from now.

What I can endeavor to do however, is explore what factors will influence asset prices going forward. As I’m fond of reminding readers who insist that posts should include some kind of concrete, bullet point summary at the end, making definitive statements is pointless precisely because while we can quantify the fundamentals, we can’t quantify what we might call “exogenous influence”.

I know, for instance, that credit is trading rich and that the fundamentals are poor. But my contention that spreads can’t compress much further is grounded just as much in the potential for exogenous factors to drive spread decompression as it is in the notion that the cycle is turning.

You get the idea.

The problem for investors in the current environment is that macro is increasingly driving markets. And macro is now almost entirely beholden to politics. That, in turn, means markets are at the mercy of geopolitical developments more so than ever before.

That of course fits nicely with what I like to call the Heisenberg raison d’être. Recall what JPMorgan’s quant wizard Marko Kolanovic said earlier this month:

Various quantitative and qualitative metrics indicate that markets have become more macro driven and react faster to the new information.

And recall my response:

Between central banks and geopolitics, markets are becoming more macro driven. At the same time, it’s becoming more important for average investors to understand ostensibly complex corners of the market and how they interact with the increasingly precarious macro environment. Indeed, Kolanovic has just described the Heisenberg raison d’être.

As I highlighted in “Boiling Frogs” and “Your Portfolio Needs The Status Quo,” there’s a general tendency for investors to extrapolate from the Brexit and Trump experiences. That’s probably a mistake.

First of all, markets collapsed after the Brexit vote and US futs collapsed when it became readily apparent that Trump was going to win. Yes, those downturns were fleeting, but they happened.

Second, we’ve seen significant FX and rate volatility as a result of political outcomes over the past eight or nine months and eventually, that’s going to spill over into equities.

The evolution of volatility (NYSEARCA:VXX) as an asset class has led to changes in market structure that, as SocGen notes, may have antiquated headline VIX as a useful measure of market angst. Don’t forget about these charts which collectively illustrate the disconnect between rates/FX volatility and equity volatility:

(Charts: Goldman, Deutsche Bank, SocGen)

Also, have a look at the following from Wells Fargo which depicts daily 10Y yield changes for three periods, one surrounding Brexit, one between Brexit and Trump, and one from Trump until now:

(Chart: Wells Fargo)

See why that’s important?

All of the outsized moves were around the big political events. Hence Wells’ amusing “hysteriagram” label. Here’s some color from the bank (my highlights):

We plot distributions of daily changes in the 10yr Treasury yield for three periods: the past two months, i.e., dawn of the Trump era, the period immediately prior to the U.S. election, and the time around the Brexit vote. In other words, one fairly tame period is sandwiched between what we consider to be the two biggest political events of the past several years. Interestingly, the 10yr’s recent moves map pretty well to its behavior around Brexit. In both cases, political uncertainty has led to market “hysteriagrams.”

Now needless to say, we’re facing perhaps the most disruptive political event yet in the upcoming French elections.

I’ve written extensively about this of late, noting that Marine Le Pen’s promise to take France…