Geopolitical Risks Impact Asset Volatility and Correlation
2016 was one of the most politically eventful years since I started my career in investment management more than 11 years ago. The impact these events have had on financial markets were as unexpected for the financial industry as the results themselves were for the entire world watching. This made positioning for and subsequently managing the risks of such geopolitical events an increasing challenge for investment managers. However, brief rises in risky assets’ volatility presents windows of opportunities for savvy hedge fund managers.
Brexit and its Impact on Risky Assets
The unexpected outcome of the Brexit referendum and then the results of the US elections sent financial markets careening in several directions. For instance, on June 24, 2016, the GBP plummeted against all other G7 currencies, losing 10% on the day and reaching a 31-year low.
Figure 1. Value of the GBP. Source: Bloomberg
In a typical herd-behavior panic, the UK FTSE 100 index initially sold off, as did the rest of the world equity market indices, losing 5.8% over two days. But by the end of the month, it not only erased the losses but even gained 3% compared to its pre-Brexit level—by far outperforming the rest of the global equity markets.
Figure 2. FTSE 100 Index. Source: Bloomberg
Investors in UK equities shrugged off concerns about Brexit uncertainty for the UK economy when they realized that a weaker pound is beneficial for the 100 biggest UK companies (represented by the FTSE 100 index), as 80% of their sales are realized overseas. A weaker domestic currency is positive for exporters but negative for importers. A market-savvy investor would have bought the UK FTSE 100 ETF when it dipped during the panic, knowing that the weaker pound would eventually cause a reversal and support the UK blue chip index.
The same knee jerk reaction was also observed in credit markets worldwide: the ITraxx Main index, comprising 125 five-year CDS contracts of investment-grade European corporations, jumped by 25% to 90 bps as a rise in the credit spreads—the cost of default insurance—implied a deterioration of the credit quality of the underlying names. Credit levels normalized less than two weeks after the referendum result, retracing to pre-Brexit levels.
Figure 3. ITRX Eur. Source: Bloomberg
Again, many fund managers sold protection on the credit indices during the peak of the market panic, betting on a retracement of the credit spreads once the full-scale impact of the political event was digested and market participants realized that a Brexit spillover to the rest of the EU causing a collapse of the union was not an imminent risk.
Uncertainty Encourages Correlation
What’s worth noting here is the rise in correlation between risky asset returns in times of high uncertainties. So depending on the perceived magnitude of the political risk, this can be days or sometimes weeks leading up to the event.
Many of the usual relationships between different asset class behaviors don’t hold during these periods, such as stock and bond prices. In periods of normal market behavior, bonds are investors’ safe haven in times of risk aversion, but when investors’ moods turn more adventurous, they typically switch their bond allocation to equities or other high-volatility assets like some hedge fund strategies. This means a relatively low to negative correlation between equities and bonds during normal market conditions.
In the run up to major political events, however, both corporate bond and equity returns tend to move in tandem as the market switches into “risk off” mode and snubs all risky assets in favor of cash or Treasuries.
Lessons Learned
A lot of similarities can be drawn between the UK referendum event and the US election, both in terms of asset correlations and price moves.
A good lesson the market learned during those events was to stay on its toes and never be complacent about the forecasted results when the outcome probabilities are within the pollster margin of error.
Many investors rushed to buy GBP against other major currencies as they tracked and believed the vast majority of the pollsters (and betting shops that also favoured a Remain outcome) and relied on prominent paper statistics that stated that in the past 30 years, 23 out of 34 elections aiming to change the current social/political system resulted in a status quo win—that is, a Remain vote was statistically more probable.
GBP was thus massively overbought a few hours only before the referendum result (as it reached 1.5 against the dollar) and those investors proved to be incorrect, as the currency slumped by 10% against the dollar in the early hours of June 24, 2016 (refer to Fig. 1).
Cautious investors would rather flatten their exposure in the run up to highly uncertain political events (in the case of Brexit, it would be by offloading any cross-currency exposures against GBP) and tactically take positions in the early hours of the event’s official results when the dust starts to settle.
For example, it was manifest that the case for a Brexit win was strengthening when Sunderland voted to leave the union by a higher margin than expected (60/40 rather than the expected 6-point lead) and the result was published in the early hours of June 24.
The trading opportunity may even become more interesting, as a likely early-hour panic of the market depresses risky asset prices and makes entry levels more attractive.
About the Author
Since February 2014, Samed Bouaynaya, CFA, has been the risk officer and director of UCITS funds at Altana Wealth, a multi-asset-class European hedge fund based in London. Samed has more than 10 years’ sell-side experience in quantitative analysis, pricing, and risk oversight of structured products across equity, credit, and rates. Prior to Altana, Samed was a credit quant analyst at JP Morgan, then an associate director at RBC Capital Markets, where he covered senior quantitative and risk roles supporting derivatives trading.