With each passing escalation in the worsening dispute between the Trump administration and America’s trade partners, market observers have been keen to try and divine something about relative vulnerability across assets.
Importantly, 2018 isn’t just a trade story. Rather, the trade frictions have served to exacerbate some of the existing problems (e.g., tariffs have raised the prospect of higher domestic inflation in the U.S. at a time when the Fed is already hyper-sensitive to nascent signs of price pressures and the prospect of a trade war denting global growth adds to the risks already facing emerging markets as the Fed tightens policy) while introducing an extra set of embedded contingencies to the overall market narrative at a time when geopolitical uncertainty was already running high.
As things stand currently, the market seems to oscillate between viewing a trade war as inflationary (for obvious reasons) or deflationary (i.e., demand destruction weighs on commodity prices and pushes growth lower, imperiling the already tenuous gains from a decade of expansionary monetary policy) depending on the perceived severity of the latest escalation.
There is no resolution in sight. As Deutsche Bank’s Aleksandar Kocic put it in a note dated Friday, “trade wars and tariffs in their early stage act as a source of temporary disequilibrium, injecting temporary volatility and dislocating markets as search for a new equilibrium takes place.”
For the time being, markets seem confused. Gold is sitting near one-year lows as hawkish Fed policy, a stronger dollar and rising U.S. short rates weigh on demand. The yen is actually the worst-performing G-10 currency in July, a state of affairs that’s confounding some investors. Even the bullish case for U.S. small caps amid the trade tensions (the outperformance of the Russell 2000 has been variously attributed to small caps’ relatively low international revenue exposure) was called into question this month by Barclays and Morgan Stanley. Notably, Barclays suggested that small caps are in fact more exposed to tariffs than their large-cap cousins.
Focusing in on the vol. space, the above-mentioned Kocic wrote the following, in the same Friday note cited above:
Despite collapse of realized volatility and soaring implied-to-realized ratios, gamma sellers seem reluctant to engage in rates indicating that apparent calm does not imply a worry-free environment.
Well, in a note to clients making the rounds on Monday, Kocic expands on that point, and what I wanted to briefly zoom in on here is what he says about the yuan, which has of course been a veritable obsession for market participants over the past several months, for obvious reasons.
Kocic notes that while realized and implied vols of CNH and U.S. equities are “doing very different things”, risk premia are tracking each other in near lockstep. Here’s realized and implied:
And here, by contrast, is the risk premium story:
“I think that both EM currencies (and EM assets in general) are responding to the same risks as DM risk assets, at least on the level of implied risk premia”, Kocic writes.
This harkens back to a flow chart he rekindled earlier this year that maps out the possible feedback loop between a stronger dollar, EM weakness, pressure on DM equities and Fed policy. Recall the following visual from “A Visual Guide To The Strong Dollar-EM- Fed Hike Causality Chain“:
There’s a walk-through for that visual in the linked post above, but for our purposes here, just note that the close relationship in S&P and yuan vol. risk premia seems to suggest that the market is well aware of the feedback loop illustrated in that flowchart.
I’ll leave you with one last quote from Kocic’s Monday missive, which is essentially a short version of the longer story the chart above is dying to tell:
I have argued in the past that turbulence in EM could have a knock-on effect on risk assets in the US. An example is the 2015 episode where asset managers faced redemptions due to EM losses and had to sell the best performing assets (US equities) to cover those costs. This means more turbulence in developed markets and possible tightening of financial conditions, which could question the strength of the USD and possibly push Fed to take a pause.