Mr. Woo And The Chickens: ‘It’s Not Too Late To Hedge’

Listen, BofAML’s David Woo has chickens on the mind.

In fact, these chickens have been pecking at David for at least a month now.

You might recall our previous discussion of Mr. Woo and his chickens:

Long story short, Woo thinks markets are underappreciating (and thereby probably mispricing) the risk inherent in two standoffs:

A showdown between President Trump and the GOP over tax reform in the fall
A showdown between the US and China over North Korea between now and the fall

He seems to have been right on both accounts because his original “chicken” notes came ahead of the recent escalation with Pyongyang and also prior to Trump’s criticism of Mitch McConnell.

Well given recent events, it was only right that Woo should provide clients with an update. You can find excerpts below…

Via BofAML

Over the past week, while a spat between President Trump and Senator Mitch McConnell has served as a reminder of the first risk, the escalating rhetoric between Washington and Pyongyang has brought the second risk into a sharper focus.

These developments have shaken the markets out of their summer stupor, and volatility has returned with a vengeance.

Meanwhile, we have a new dilemma: whether to take advantage of the repricing in the market to cash in our hedges or add to them. This is not the first time the threat of military confrontation on the Korean Peninsula has loomed and tension has brewed in Washington. Previous such crises often proved to be short lived and were followed by rapid recovery in the market.

Yet, we cannot help but to think this time things may be different.

Let’s recall the game of chicken — two drivers on a collision course with each driver trying not to swerve before the other driver. There have been at least three separate occasions over the past twenty years when the market was bracing for a possible military confrontation only to see the two sides both swerving before the collision.

In our view, what makes the current crisis fundamentally different from previous ones is the pressure of time. We think the possibility that North Korea may be only a year away from being able to launch a nuclear ICBM that could reach the US reduces the incentive of both Washington and Pyongyang to swerve. Washington can no longer afford to kick the can down the road, and the benefit to Pyongyang of suspending their nuclear program diminishes the closer they are to crossing the nuclear threshold. Indeed the latest UN sanctions on Pyongyang may only increase the cost of inaction for the North Korean regime.

The fact that time is not on the side of either player means the outcome of the game has become much more unpredictable, in our view. To us, this aspect of the crisis alone justified the repricing of risk premium last week, and it is reasonable to think the repricing has not run its course (Chart 1).

That said, we would also urge against overreaction. Game theory tells us very clearly that neither side would have an incentive to take unilateral military action, given the potential for great numbers of casualties on both sides.

This is the reason why we continue to think that the actual game of chicken is between Washington and Beijing and not between Washington and Pyongyang. We suspect Washington’s increasingly stern tone is calibrated to pressure China to find a nonmilitary solution (i.e., more economic sanctions that will force North Korea to capitulate). President Trump’s comments last week were probably meant for Chinese ears. The US success in getting China to agree to the August 6 UN sanctions may have emboldened Washington to think that China might bend to further pressure.

In our view, this calculation is where the real uncertainty lies — what Beijing is prepared to do to comply with Washington’s demands and whether it will be enough. We think investors should take this into account when considering hedging against or rebalancing their portfolios.

Even if the present crisis on the Korean Peninsula were to somehow resolve itself in a peaceful manner, Washington faces another battle in September over the 2018 budget and the raising of the debt ceiling. We have argued that these may represent the last levers President Trump has over his party over tax reform — he may resort to threaten a shutdown or even a default to force his party to pass tax reform. In other words, we believe September is unlikely to be less volatile than August. With volatility still low by any stretch of the imagination, it is not too late to hedge.