Elevated volatility still a feature with markets sensitive to geopolitics

Macro Outlook

Markets will tend to take the stairs up and the elevator back down. With a raft of geopolitical events creating a mass wave of caution and flow into safe haven assets, equity markets have come under a wave of selling pressure that has seen billions wiped of global markets on a daily basis. Retaliatory sanctions engaged by Russian on the EU and US have the potential to have a sizeable negative impact on European trade. However, now, investors are having to contend with another geopolitical event, this time in Iraq. With President Obama agreeing to the use of US military air strikes in northern Iraq in an attempt to prevent the “mass genocide” of the Kurds, global investors have seen uncertainty mount. In these market conditions, the one big winner is volatility. The VIX Volatility index of S&P 500 options is elevated at levels not seen since April, with average daily ranges on some forex pairs such as Dollar/Yen and Euro/Dollar increasing significantly. One big concern for equity investors is that yields on the safe haven government bonds (eg. Treasuries and Gilts) has broken to their lower for over a year. This does not bode well for longer term appetite for risk that has been pulling these markets higher for so long. Whilst market are being driven by geopolitics, trading will remain very choppy.

Must watch out for: UK Bank of England Quarterly Inflation Report

Impact: Market chatter is that hawks on the MPC (most likely Martin Weale and Ian McCafferty) are ready to dissent against the consensus view of 9-0 in favour of keeping rates flat. We will not know the voting structure of the latest MPC meeting until 20th Aug, but the Quarterly Inflation Report projections on inflation and growth gives vital clues over when members may begin to vote for a rate hike. Increased inflation expectations will be key. Expect sterling to move significantly on the release with volatility in EUR/GBP and GBP/USD.

Foreign Exchange

In his press conference for the latest ECB monetary policy decision, Mario Draghi explicitly tried to talk the euro lower. Towards the end of the press conference he noted the divergence in monetary policy between the ECB on one hand and the Bank of England and Federal Reserve on the other. Draghi would much prefer to talk the euro lower, rather than have to engage outright QE in order to depreciate the euro. However this attempt appears not to be working. The euro has been sold-off significantly in recent weeks and, taking a step back, the market has begun to support it once more. This is likely to be just a near term reaction, but some of the moves on crosses against the US dollar and sterling have been decisive. The announcement of German and French GDP data this week could be crucial for how this apparent technical rally develops; whilst specifically the rally against sterling could all hinge on how hawkish the Bank of England’s inflation and growth projection fans are in the Quarterly Inflation Report. However, for now , Mario’s latest jawboning attempt seems to be falling upon deaf ears.

WATCH FOR: Safe-haven currencies such as the yen and the Swissy could be volatile to Geopolitical news flow, but the forex markets will be concentrating largely on the raft of GDP data out of Japan, Germany, France and the UK. Sterling traders will be fixated on the Bank of England’s Quarterly Inflation Report.

Indices

Anyone bemoaning the lack of volatility in equity markets will have been more than satisfied in the past couple of weeks. Equity markets around the world have been in precipitous decline with a series of geopolitical concerns mounting. Despite probably the strongest earnings season for a long while, corporate announcements have been dwarfed by concerns over the economic impact on sanctions and counter sanctions with Russia and latterly the prospect of US military intervention in Iraq. Equity markets with close links to Russia (notably the German DAX Xetra and the French CAC 40) have been significant underperformers in this environment and can be expected to continue to be so. For months, commentators have been talking about stretched valuations on equities (the S&P had been trading on around 19 times historic earnings, or 25 times if you consider the cyclically adjusted price earnings). Calls for a potential 10% correction which had been sniffed at by the bulls don’t seem so unrealistic now, and I will not dwell on how well a call to “Sell in May and go away” has worked out. Equity markets are now technically becoming stretched to the downside, but whilst the geopolitical tensions remain elevated it will be difficult to muster the buyers to form a recovery of substance.

WATCH FOR: Tensions with Russia still remain paramount for investor risk aversion, whilst Iraq now just adds to concerns. With little left of earnings season of any note, investors will hope for good news from Japan, Germany, France and the UK. There is little out of the US to rock the boat this week.

Other Assets: Commodities & Bonds

Take your pick from a raft of different geopolitical tensions (Gaza, Ukraine, Iraq…) and this all adds up to renewed upside in precious metals and the price of oil. Gold has arrested a decline and is looking to break higher again. This is also coming just as we approach the key Indian wedding season (September), Diwali (October) and Golden Week in China (October) all of which should be supportive for gold. Oversupply and weak demand has dogged oil prices recently, but as President Obama authorises air strikes in northern Iraq, this could impact Iraqi supplies and prices are rising again.

With flight away from risk related assets, investors have been driven back towards the safe haven of US Treasuries and UK Gilts. The yields on both countries’ 10 year debt have fallen to at least 12 month lows now. In the Eurozone, renewed disinflation (inflation fell to 0.4% from 0.5%), coupled with Italy falling into technical recession has also driven yields lower. The yields on German and French 10 year bonds have been plumbing new lows.

WATCH FOR: Geopolitical developments across Ukraine and Iraq escalating which could drive precious metals and safe haven government bonds higher in the search for safe haven investments.