One of the interesting things about being in the proverbial loop when it comes to market commentary is that you’re never really sure whether a given narrative is “real” because it accurately describes the current environment, or whether it only became “real” because the Street penguin procession all parroted what one guy said thus transforming something that may have been one analyst’s opinion into prevailing wisdom.
To the extent prevailing wisdom doesn’t accurately reflect conditions, you get glaring disconnects between what the “smart” people say, and what actually plays out in markets.
A good example of this phenomenon is the contention that the Brexit vote reinforces the nationalist/isolationist/
We think that narrative has merit (a lot of it) and will eventually drive markets right off a cliff. That notion is reinforced by lofty valuations. But so far, the market is saying something different - essentially, it’s saying “we think all the talk of political risk is either exaggerated, outweighed by central bank stimulus, or both.” Here’s how we put it on Monday:
“Equities haven’t been this expensive since the crisis and before that, since the aftermath of the dot-com collapse. What makes this especially interesting in the context of the UK referendum isn’t so much the market’s resilience to the vote itself, but the market’s resilience in the face of what the vote signals about the willingness of the electorate to vote for radical change.”
Let’s assume the political chickens do indeed come home to roost. That is, let’s take it as a given that eventually, some geopolitical event will be black swan-ish enough to spook markets in earnest (although if a military coup in a NATO member country isn’t enough, then one wonders what is). What are the potential landmines going forward? Here’s an excellent graphic from Deutsche Bank that delineates possible political speed bumps:
(Graphic: Deutsche Bank)
And here’s the other side of the story (i.e. the reasons contagion risk seem low, also via Deutsche):
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Spain: worse than expected performance for radical left
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Podemos in the immediate aftermath of Brexit
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Italy: leader of eurosceptic 5 Star Movement publicly declared his support for staying in the EU to reform it from within
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France: opinion polls suggest Remain still enjoys comfortable lead in case of referendum
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Austria: far right presidential candidate publicly supported the country remaining in the EU
But it’s not so much that we think the EU is actually going to disintegrate or that Frauke Petry will be able to continue her meteoric rise in German politics or that Donald Trump will really become President in the US (please note: none of that is a comment on whether those would necessarily be good or bad outcomes, it’s just to say those are examples of events that would be traumatic for markets), rather, it’s the fact that we’re even having these conversations that’s disturbing.
It’s kind of like that time in March of 2014 when President Obama said the following with respect to the threat posed by a resurgent Russia: “I continue to be much more concerned when it comes to our security with the prospect of a nuclear weapon going off in Manhattan.” It’s like “wait, who said anything about an atomic bomb exploding in Manhattan?!”
Same principle with today’s political landscape.
You know it’s unlikely that nationalistic sentiment is going to boil over and trigger some kind of horrific 1939 redux, and it’s equally unlikely that any of the candidates feeding off that nationalistic sentiment actually intend to do anyone harm. But the point is, if you’re out there holding an equity portfolio that’s collectively trading at 20X while staring at a 12 handle VIX, you don’t really want to hear people debating about whether epochal, seismic, and/or potentially destabilizing geopolitical outcomes are about to occur. In fact, you want exactly the opposite: you want the waters to remain exceptionally calm.
The status quo may be a real bummer when it comes to bemoaning the sad state of politics inside the Beltway, but status quo is exactly what you want if you’re long a market that’s priced for absolute perfection. Pick your poison we suppose.