WHAT TO WATCH: How to Trade 4Q as Political Risks Dominate
(Bloomberg) -- Political risk is rising and economists from the IMF and Fitch among others are warning that it poses a threat to global growth. With several political events dominating the calendar, here’s a look at how investors could position in the final months of the year.
- Any signs that ECB might start tapering stimulus sooner than expected may prompt markets to price political risks more aggressively, BofAML analysts say
WHY DOES IT MATTER?
- BlueBay’s Mark Dowding says politics will be key for markets in the 4Q, with a Trump victory in the U.S. presidential vote a possible spur for a meaningful risk-off move, suggesting caution is warranted
- BlackRock Richard Turnill advocates exposure to portfolio hedges such as gold and short-term Treasuries
- Citigroup’s Steve Englander says investor reluctance to position means implied volatility in FX, EM and rates is very low relative to the underlying risk
- Raises risk that prices move too fast for investors to respond and the possibility that one-way markets lead to overshooting, he says
- Investors have remained somewhat immune to deteriorated fundamentals and heightened political risks, but that may not be the case if they thought ECB tapering was coming as soon as March, BofAML analysts Ruben Segura-Cayuela, Chiara Angeloni, Gilles Moec say
WHAT’S HAPPENING?
- U.S. ELECTION
- The second and third debates between Hillary Clinton and Donal Trump on Oct. 9 and 19 may set the tone ahead of the U.S. presidential vote on Nov. 8
- UBS analysts led by Nishay Patel think increased volatility into the election should mean lower long-end rates; favor nominal/real (7s30s) flatteners
- Morgan Stanley analysts including Andrew Sheets say the U.S. vote and the Italian referendum in December could spur a major market impact as volatility curves around the events are flat, yield differentials are low
- They favor owning rates vol and say curves should be steeper; recommend shorts in BTPs vs USTs and buying U.S. stocks vs European equities which offer inexpensive hedges against higher political risk premium
- Deutsche Bank analysts say yield curve is biased higher, steeper should Trump win; USD to advance more strongly on a Clinton victory
- ITALY REFERENDUM
- The vote on constitutional reform is scheduled for Dec. 4, just days after troubled bank BMPS is due to meet with shareholders; polls show a significant share of voters still undecided on whether they will back PM Renzi’s reform; see latest polls here
- While early elections are unlikely, a no vote will still open a new phase of political instability in the country, BofAML analysts say
- The outlook for Italy’s bonds splits investors; UBS recommend hedging against a potential escalation of Italian risks by selling 10Y Italy vs USTs, targeting a spread of 0bp
- Stick to their recommendation to be long 10Y Spain vs Italy
- Intesa Sanpaolo analysts though say the balance of risks between the two countries seems level so spread positions between them offer an unappealing risk-return trade-off
- BREXIT TALK HARDENS
- Sterling is near multi-decade lows vs the dollar as initial enthusiasm about the better-than-expected economic performance since the vote to leave the EU has been overshadowed by concerns Europe’s leaders may be steering the U.K. toward a hard Brexit
- BofAML analyst Kamal Sharma says the Europeans are taking a hard line and this should weigh on GBP over the coming months
- Reiterates his view that GBP is a sell on rallies and will be paying close attention to U.K. sovereign CDS
- Deutsche Bank remains resolutely bearish, favoring shorts in sterling on a trade-weighted basis against dollar and euro while Credit Agricole’s Valentin Marinov says sterling should consolidate and even regain some lost ground before long
- MERKEL’S FATE
- German chancellor Angela Merkel’s political future is increasingly linked to Deutsche Bank’s fate as any bailout, were it needed, could damage her chances of being re-elected next year
- SocGen says while much has been done to reduce risks in the banking sector, and central banks stand ready to act, finding an effective solution in the current context may involve a good dose of politics
- Eurasia’s Mujtaba Rahman says the bank has sufficient cocos to mean a state bailout wouldn’t be needed, Autonomous says it could do a rights issue, BNP suggests it could exit its investment banking business and Societe Generale says a consolidation of the German banking system supported by government sweeteners is possible
- While not likely, Merkel no longer being part of the German government would be a step change in terms of the ECB’s ability to react, Simon Smiles, CIO at UBS WM Ultra High Net Worth, said in interview
- There’s a widespread view that Merkel and Draghi have been the sources of leadership in the region as they have done an incredible job working together; if you take those two key players away, it’s a source of uncertainty
- PORTUGAL DECISION TIME LOOMS
- Portugal bonds remain at the mercy of risk sentiment as investors wait for news from rating company DBRS that could see them frozen out of the ECB’s QE program
- BlueBay’s Mark Dowding says fears surrounding Portugal are overstated and points out DBRS maintained an IG rating on the country throughout the sovereign credit crisis, when Portugal lost bond market access and was forced into a EU bailout program
- BlueBay maintains a net long position in Portugal
- While a downgrade isn’t SocGen’s base case either, analysts at the bank note were it to happen PGBs would no longer be eligible for ECB liquidity and QE and the country’s banks would likely need to rely on ELA
- Portugal’s weak fundamentals, market tensions would no doubt re-emerge in such a risk scenario setting Portugal on course for a second bailout, they say
- PGBs may be set for a rebound as Portugal’s fiscal situation remains under control, JPM analysts including Gianluca Salford say, while UBS analysts say PGBs have substantial room to sell off were Portugal to lose market access, or in a situation of generalized risk aversion
- SPAIN ELECTION RISK REMAINS
- SPGB spreads over bunds flirted with new year-to-date tights as splits in the Socialist PSOE party spurred hopes the political impasse in the country may be concluded by the end of the month
- Following the departure of Socialist leader Sanchez, a PP-led government looks increasingly likely, RBS wrote in a client note; they favor buying 10Y Spain, targeting 0.40% given country’s public debt levels are low and fundamentals are improving
- Meanwhile Rabobank analysts say the spread over bunds has failed to break the 100bps level sustainably since 2014
- And in any case, there’s no certainty that fresh elections will be avoided, says Eurasia’s Federico Santi and Teneo’s Antonio Barroso
Alert:
HALISTER1Source: BFW (Bloomberg First Word)
Tickers 2539Z GR (European Central Bank)
People Andrew Sheets (Morgan Stanley)
Angela Merkel (Federal Republic of Germany)
Antonio Barroso (Teneo Intelligence)
Chiara Angeloni (Merrill Lynch International)
Donald Trump (Trump Hotels & Casino Resorts Inc)
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