Once upon a time — say, a decade ago — equity and debt investors classified countries into two buckets.
There were “emerging markets” countries, where investors often had to price in political risk due to fragile institutions, capricious leaders or populist swings. Then there were “developed” countries, where the political institutions were presumed to be so stable that risks could be measured with spreadsheets and uncertainty was driven more by policy than the political process itself.
No longer. Even before the full swing of the US presidential election exploded on to television screens this autumn, investors had started to realise that the source of political risk and instability is shifting between developed and emerging markets.
This week Matthew Chamberlain, head of the London Metal Exchange, told me that, in the commodities markets, it is events in western markets that tend to create price volatility, while China has become a relative source of stability. “It’s a big change” for investor psychology.
Events in the US now offer a more striking example of change. In recent weeks the movement of derivatives prices suggests investors are scrambling to buy contracts to protect themselves from wild volatility in asset prices around next month’s election. Indeed, they are arguably doing this more frenetically than market professionals have ever seen for a US election.
“The 2020 presidential election has seen an historically wide margin of event risk priced across asset classes by options markets,” a JPMorgan client note observes, citing equity, rates and credit sectors as the key asset classes affected.
What is doubly striking is that these derivatives swings extend far beyond contracts for November 3, the putative election date, into 2021. At best, that suggests investors fear an extensive dispute around the results, comparable with what happened in 2000. At worst, they fear violence or an impasse where President Donald Trump refuses to leave the White House if he loses. “We are trying to price in a whole new type of risk,” says one hedge fund boss.
The issue is not whether a victory for Democratic candidate Joe Biden, say, would cause a rally in green assets (although it almost certainly would). What really unnerves investors is the prospect of trust in the wider political process breaking down. “Social conflict [fears] are now affecting developed markets too,” Henri Wallard of AXA insurance observed, citing a new survey.
Some asset managers are reacting to this by withdrawing to the sidelines, particularly given the rising cost of protection. “It is getting more and more expensive to hedge the election results,” a note from Weiss Multi-Strategy Advisers, a hedge fund, said recently.
Others are developing new compasses to track political risk. Because national polls were a bad guide to predicting the election results in 2016, there is rising investor interest in using political prediction and betting markets as well, particularly as implied projections can differ from polls. (Earlier this year betting sites gave Trump a better chance of victory than the polls, but this has now narrowed.)
And while the betting sites have relied on fairly crude methodologies so far, some entrepreneurs are trying to improve these amid customer demand. “Political markets have been a poor cousin of sports betting before. But it is rapidly growing up,” says Jose Garay, a Spanish entrepreneur who is building a platform called Guesser.
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Sell-side firms are reforming their risk tools too. JPMorgan is a case in point. Last year it took the (then novel) step of launching a so-called Volfefe index to track how Trump’s tweets shape futures prices. This month it updated the tool in response to rising election uncertainty. “Non-traditional measures of political uncertainty have become increasingly useful in terms of assessing volatility in interest rate markets,” it explained to clients. In plain English, bankers are grappling with the bizarre.
An optimist might view this as just a sign of Wall Street’s evergreen love for innovation. A cynic might point out that the presence of these tools means most US election event risk is already priced in — and the real “shock” would be a normal election.
Either way, the saga shows the degree to which America’s role on the world stage is shifting, as investors rethink their late-20th-century assumptions. That is unlikely to change any time soon; even if Mr Biden does win the White House, as both the betting markets and polls imply he will.