All Quiet On The Western Front?

All quiet on the Western front?

Well, not exactly.

Western democracies are actually in a state of turmoil right about now (get it? “right” – there’s a rare triple entendre in there if you’re looking hard enough), thanks almost entirely to a still-simmering, semi-global populist revolt that should have died with Marine Le Pen’s trouncing in the French elections, but which has survived thanks to Donald Trump’s ongoing efforts to undermine multilateral institutions and otherwise sow discord in Europe. Most recently, those efforts involved suggesting the U.S. may pull out of NATO and endorsing Boris Johnson for U.K. Prime Minster. Matteo Salvini’s growing influence in Italian politics has lent further support to the anti-establishment movement.

The upending of traditional Western alliances and the concurrent realignment of politics in developed countries is mirrored in the Trump administration’s adversarial trade policy which, taken to its logical (or illogical, whichever the case may be) extreme, entails the U.S. abandoning the WTO.

Western financial markets have remained relatively resilient in the face of the trade tensions, depending on which markets you’re looking at and how you define “resilient”.

Obviously, European automakers have suffered and the recent outperformance of U.S. small caps (outperformance which has suppressed the Russell VIX relative to implied on the S&P) hints at investor consternation on trade. But generally speaking, the U.S. and Europe have yet to see anything that approximates the type of angst reflected in the Shanghai Composite’s plunge into bear market territory and the large outflows from Asia EM.

But it’s not, as alluded to above, “all quiet”. Consider these excerpts from a Bloomberg article dated, appropriately, Friday the 13th:

Stocks are hobbling along; options traders worry they’ll fall. The Cboe put-to-call ratio for equities, tracking volume in bearish versus bullish bets, averaged 0.6 in the 10 days through Wednesday, the highest since early May. The ProShares Ultra VIX Short-Term Futures ETF, which rises when volatility goes up, has attracted $230 million of new money this month, doubling its assets.

Most of the nervousness is being felt in individual stocks and enough industries are doing well that the effect is masked when you look at indexes, said Victor Lin, a Credit Suisse strategist. A lack of lockstep moves has been one of the market’s signature qualities for the last few months, pushing correlation to a five-month low.

In the same vein, Deutsche Bank’s Aleksandar Kocic wrote the following in his latest weekly missive:

Despite collapse of realized volatility and soaring implied-to-realized ratios, gamma sellers seem reluctant to engage indicating that apparent calm does not imply a worry-free market.

The reference there is probably to high ratios in rates and credit.

“Worry-free” is most assuredly something that traders and investors are not in the current environment. That isn’t to say that folks aren’t still clinging to the idea that trade tensions won’t ultimately result in a worst case scenario (although David Woo has seemingly given up).

In their latest rates and FX survey conducted on 06-11 July and representing the views of 58 fund managers responsible for $286 billion in AUM, BofAML found that while 64% of respondents believe trade tensions are set to get worse, the accompanying adjective  “modestly” seems to betray a lackadaisical attitude.

“Despite recent escalation, investors are sanguine on the impact of trade tensions, with most investors expecting only a slight or negligible impact on global growth,” BofAML writes, in the note from which that visual is pulled.

Perhaps the summer lull has put folks to sleep despite Donald Trump’s best efforts to keep everyone “woke” (and we’re talking about Trump here, so in this context, “woke” most assuredly doesn’t mean “progressive”).

But to the extent market participants are concerned, it’s down to trade. Here’s Deutsche’s Kocic again:

In the center of the underlying market concerns are the tensions created by the most recent political developments. Trade wars and tariffs in their early stage act as a source of temporary disequilibrium. They inject temporary volatility and dislocate markets as search for a new equilibrium takes place.

The paradox here is that depending on how things play out, tariffs have the potential to be inflationary (for obvious reasons), but could also be deflationary to the extent they precipitate demand destruction. Wednesday’s brutal commodities selloff seemed to suggest people are beginning to worry about the potential for trade frictions to materially dent global growth.

And with that, I’ll leave you with one last quote from Kocic:

With trade wars and tariffs being a destabilizing force and a possible catalyst for a risk-off trade, there could be continued threat of bullish reversal at the long end of the curve. At the same time, the inflationary overtones of these same tariffs and their possible interference with growth could take the economy in the unwanted direction where it would be difficult to find an adequate monetary policy response. This could be one of the main reasons behind the market’s reluctance to short volatility at this point.