PERHAPS, THE END OF THE BEGINNING
The rise of authoritarian populist leaders like Donald Trump, Marine Le Pen, Norbert Hoffer, Nigel Farage, and Geert Wilders have dramatically changed the political and economic landscape. The driving force of their support has stemmed from two key factors: economic inequality and progressive cultural change. Yet, the distinction drawn between these factors may, in fact, be artificial. The evolution of developed economies to require higher education and significant specialization coupled with a shift in cultural values creates a feedback loop for most Western Democracies that has effectively ostracized a subset of the population. We now understand the economic, cultural and political division created by these changes cannot be bridged. The growing division in Western societies is likely to increase irrespective of any improvement in the underlying economic conditions of these countries. The orthogonal pull of socioeconomic politics will continue to generate tensions with mainstream parties, unpredictable political contests, and an increase in anti-establishment populist challenges to the legitimacy of liberal democracy. The new regime of high political uncertainty is here to stay.
HIGH POLITICAL UNCERTAINTY ≠ HIGH VOLATILITY
Volatility across most major asset classes is at multi-year lows despite political uncertainty reaching a multi-year high. On the surface this appears to be a sharp contradiction. High policy uncertainty should have a negative impact on economic growth, and historically high policy uncertainty is positively correlated with higher VIX levels. Yet, this correlation obfuscates the direction of causality. Contrary to our intuition, high equity volatility causes high policy uncertainty, not the other way around. As such, the current environment of high political uncertainty and low volatility should not lead to an investment thesis of being long volatility. Due to the structural dynamics of investors specifically delineating the winners and losers by sector, realized equity correlations have declined to the lowest level since 2007. This creates large moves at the sector level, but depressed realized volatility at the index level, epitomized by the S&P 500 which has realized volatility of just 5.9% during the first two months of 2017. We benefitted from these dynamics in our volatility portfolio during 2016 where at different times we were sellers of correlation on SX5E, DAX, SPX, and US financials. The current environment is less attractive for these trades given the sharp decline in implied correlation, but has become more attractive for cross-region and cross-asset correlation and volatility investments.
Economic progress continues to be driven by the division of labor as predicted by Adam Smith. These divisions have evolved to create a global economy of hyper specialization. For example, upon the completion of this commentary, our marketing team in Rhode Island will update the formatting and send the document to our compliance team in New York, who will review and approve the language and then send the document to our web development team in India to post the final version to our website.
The division of labor leads to improved efficiency, but also creates investment dislocations for those of us bold enough to focus on multiple asset classes and regions. We have typically observed the largest dislocations in implied volatility and implied correlation because these measures are byproducts of investments that are very often directional and agnostic to these metrics. For example, the purchase of Eurostoxx index options by Japanese investors in yen (quanto) creates a market for implied correlation of Eurostoxx vs. EURJPY that has recently ranged from 0 – 10% despite historical 1-year realized correlation being 54%. We see similar dislocations across developed equities vs. developed FX and developed equities vs. emerging market FX. More recently, we have identified dislocations in the relative pricing of tail risk across regions. We have added positions that are long NKY and SX5E variance vs. short SPX variance for near an even spread (at the 3 and 4 year points on the volatility curve). The NKY and SX5E have been significantly more volatile than the S&P 500 during all periods over the last 20 years. In addition, from a macro perspective we think the current economic risk of these countries far surpasses that of the US.
HIGH FRAGILITY = LOCAL TAIL RISK
We continue to observe the fragile nature of global asset classes. Volatility becomes overly suppressed during normal periods, which sows the seeds for the next short-term shock. This creates an environment that has artificially low volatility but high fragility creating a probability distribution that has high local tail risk, but low absolute tail risk. In this environment, we are protecting the portfolio from these tail events through our macro positions as well as our equity vs. FX correlation positions, which minimizes the need for outright hedges. We have also actively traded around our macro themes in Q1 2017 to help us better capture these structural dynamics. The current portfolio is well positioned for an extended period of high fragility.