(Black) Swan Lake

One of the themes that dominated in 2017 was the glaring disconnect between geopolitical/policy uncertainty and market-based measures of volatility.

Quite a bit of the uncertainty emanated from Donald Trump. Healthcare overhaul failed, the tax cuts and fiscal stimulus were delayed and generally speaking, rates and FX had priced out his entire agenda by August. Then came “fire and fury” and weeks later, the Charlottesville debacle. Those two episodes underscored how truly tenuous the geopolitical landscape was and how fractious domestic politics had become in the U.S., respectively.

In Europe, the threat of populism never truly subsided despite Marine Le Pen’s decisive loss to Emmanuel Macron. AfD’s stronger-than-expected showing in the German elections made it clear that the populist narrative still resonated and would likely continue to haunt the bloc going forward.

Through it all, dips were bought/vol. spikes were sold and the disconnect between news-based measures of uncertainty and market-based measures of volatility widened materially. See: “The Great Disconnect: 5 Reasons Why Volatility Is Detached From ‘Chaotic Uncertainty’”

Here’s a snapshot of that disconnect from September:


And in the interest of satisfying your nostalgia for “better” times, here’s what cross-asset vol. looked like vis-a-vis history around the same time (the following is from an October Goldman note):


Fast forward to July of 2018 and the landscape has changed. The low vol. spell was broken for equities in February and although things have since calmed down and despite the fact that FX vol. has yet to reflect the type of panic you’d expect to see considering currencies should be on the front lines in the event the trade war spirals out of control, we’re clearly “not in Kansas anymore” if what you mean by “Kansas” is the environment that persisted last year.

The political scientist in me is predisposed to couching damn near everything in terms of geopolitical tensions and policy uncertainty. I used to have to check that tendency at the door in order to avoid ascribing political causation where there was none, but now that geopolitics has become inextricably bound up with economics (thanks in no small part to the trade war and to the fact that if you strip away the xenophobia, the appeal of populism anno 2018 depends to a great extent on the notion that globalization is killing the Western middle class), my cross-disciplinary approach to market analysis is not only useful, but in fact something of a prerequisite when it comes to talking intelligently about the outlook from various asset classes.

It’s with that as the backdrop that SocGen is out with the latest version of their semi-famous “Swan Chart” which, for the uninitiated, they describe as “an attempt to quantify up- and down-side risks to the economic outlook which we can identify.”

And yes, SocGen realizes quantification and identification isn’t compatible with Nassim Taleb’s definition of “black swans”:

In this sense it is entirely different from Nicolas Taleb’s definition of Black Swans, which cannot be anticipated, much less have a probability ascribed to them. In these examples, the probabilities of occurrences are illustrated in the parentheses and the impact of the event given by the size of the swan. Simply put, the larger the swan, the larger the impact on the global outlook. In the following sections, the actual price impacts are given.

Ok, so here’s the latest version of the chart:


What’s changed since the last version, you ask? Well, for one thing, the chances of a European political shock rose from 10% to 25%, reflecting ongoing uncertainty in Italy and of course the risk that Brexit goes off the rails.

Everything else is essentially unchanged, but the color is worth excerpting. Here are a couple of passages worth a skim:

Given the complexity and interconnectedness of global supply chains, the net effect of a full-fledged global trade war will only be determined over time. One thing is however clear: rising protectionism, slower global trade and souring trade relations will ripple through financial markets and affect every asset class. As such, and while we remain hopeful that tensions cool in the near term, a global trade war involving China, the EU, the US, Japan and NAFTA currently represents the largest system-wide risk for financial markets.

Given the continued thaw in inter-Korean and North Korea-US relations, we considered removing the risk of a military conflict on the Korean peninsula altogether from our Swan Chart. However, we have symbolically kept it at a probability of 0.5% (last autumn we put it at 2%). This is now admittedly a very small risk, but because of its massive potential consequences we decided to keep it in the chart. Even excluding the use of nuclear weapons, a scenario involving substantial use of conventional weapons and inflicting substantial damage to northern parts of South Korea — where much of its tech industry is located — would have severe consequences for the global economy. Given South Korea’s pre-eminent position in the production of memory semiconductors, D-RAM and LCDs to name but a few, global production of goods that rely on these components could be hampered severely.

We see no change in the China hard landing risk, which we believe is stable at 15%. Our definition of a hard landing is a reduction of GDP growth by 2pp or more over the course of one year, which would leave growth at the end of 2018 at less than 5% yoy.

The risk of a sharp financial market repricing remains, but after the attack of nerves in lateJanuary/early February, when the S&P 500 plunged about 10% in less than two weeks and volatility surged, things have calmed down. Even while US 10-year yields marched to 3% and above, the VIX trended lower. That said, equity valuations remain highly demanding, especially in the US market, so the risk of a sharp repricing is clearly still present, not least as central banks are easing away from ultra-accommodating policies.

That was all written last month, and given what we’ve seen in Chinese equities, the yuan and most recently, in renewed tensions between the U.S. and North Korea, it’s probably worth reassessing the subjective probabilities around a hard landing in China and an escalation on the Korean peninsula.

Oh, and one more thing, economic policy uncertainty in the U.S. is at its second highest level in series history:


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One thought on “(Black) Swan Lake

  1. ‘How uncertain are we about economic policy? Let us quantify it and put it on a chart.’ They will make squiggly lines about anything.

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