For the past 3 months, Bank of America strategist David Woo has been warning that the market is precariously unbalanced, and as a result the smallest shift away from being "priced to perfection", or spike in volatility, could lead to a waterfall event. As we first reported back in July, Woo first warned that between the ongoing standoff in Washington, and the seemingly endless showdown with North Korea, there are two "dangerous" games of chicken afoot, both of which could culminate in a market crash. Woo even want on to lay out two "chicken" payoff matrices, one focusing on the ongoing "tax reform game"...
... the other on the "US-China game over North Korea."
So far, however, not only have these two games not culminated in any of the proposed negative scenarios, but as a result of the unstable equilibrium that has since developed, markets have successfully pushed on to all time highs.
So what's going on here?
Well, as the increasingly frustrated Woo writes in a follow up note today, "nothing has changed in September so far. Nothing at all. Equity markets are still making new highs while rates volatility is making new lows, credit spreads remain near record lows, and investors just cannot buy enough EM assets."
Still, while not validating his bearish case, Woo admits that "financial markets continue to take cues from economic data that are painting a global synchronized recovery with little inflation pressure."
The just released August PMI data show that the longest streak of simultaneous manufacturing expansion in the US, China and EMU since 2010 is extending further (Chart 1). Growth momentum looks healthy and balanced: manufacturing new orders are in expansion territory for all of the nine largest economies in the world (Chart 2). All this with continued subdued price pressure.
And yet despite the seemingly benign macro and economic environment, and record S&P, BofA clients are increasingly on edge, very much like Goldman's clients, who last week had just one question “Is an equity correction imminent?” As Woo adds, "against this benign economic backdrop, the question we are getting the most from clients (institutional and corporate) is what could possibly go wrong?"
To this, BofA's answer has been the same in the past three months:
"political risks are less benign than economic risks. We continue to believe that the greatest political risks are the showdown ahead over US tax reform in Washington and the brinksmanship between US and China over North Korea. With both coming to a head in the coming weeks, we believe that markets have not fully appreciated their significance and market implications."
As a result, expecting the two ongoing games of chicken to finally come to a violent, and risk-negative conclusion in the coming month(s), Woo retains his bearish stance, while taking stock of recent developments and provides an update of the bank's view on how to position for these risks.
First on Tax Reform, BofA remains skeptical that a favorable outcome will manifest itself. Furthermore, even if a deal is reached, its implications, especially for the bond market would be to send rates higher, sparking a potential jump in rates vol that could trigger a similar reaction across equities. Furthermore, Woo also warns that the likelihood of a government shutdown has also risen proportionately
As Congress returns from summer recess, the momentum behind tax reform seems to be picking up. Kevin Brady, the House Ways and Means Chairman, promised last week to release the long-awaited tax reform plan on September 25, complete a budget by mid-October, and move onto drafting the tax reform legislation shortly after.
However, there are few signs that Republican leadership has resolved their differences over critical details of tax reform (such as the new rates, how tax cuts will be paid for, whether tax deductibility of interest expenses will stay, just to name a few). Orrin Hatch, the Senate Finance Committee Chairman, summarized the state of the affairs last week by pronouncing that his "Finance Committee will not be bound by any previous tax reform proposal or framework". He added that "We are not anyone's rubber stamp." If this is the result of four months of negotiation, it does not bode well for the stated goal of the Republicans to complete tax reform before year-end.
Meanwhile, President Trump made a decision to side with the Democrats against his own party to raise the debt ceiling and keep the government funded until only December 15. Many commentators have suggested this reflects Trump's frustration with the slow progress on tax reform. We view this as a potential turning point for tax reform.
The strategist lays out three takeaways from Trump's unexpected move that could have potentially important market implications:
1. An increased likelihood of tax reform ultimately getting done, a scenario that would lead to a higher USD and higher TSY yields:
The failure of healthcare reform was a lesson about the risk of putting all the eggs in one basket. By siding with the Democrats, Trump shows he is open to a bipartisan approach to doing tax reform. An alliance between Trump and the Democrats makes sense at many different levels. To begin with, there is probably more common ground between Trump and the Democrats on fiscal policy (e.g., more infrastructure spending; lower income tax for the middle-class; higher income tax for the rich) than between Trump and his own party. Moreover, by reaching out to the Democrats, Trump may be trying to pressure the Republicans to move more decisively on their own tax reform proposal. The fact that Treasuries sold off and the USD rallied last week would suggest that the market agrees that a bipartisan approach could breathe new life into tax form.
2. An increased likelihood of a deficit-financed tax reform, a scenario resulting in higher rates and steeper curve, as well as a higher USD in the short-term but lower USD in the medium-term
A bipartisan approach could potentially remove currently the biggest road block to tax reform. Because the Republicans control only 52 seats in the Senate, a partisan tax reform bill will need to go through the reconciliation process that requires any tax cuts to be deficit neutral over ten years. This constraint implies either undesirable small tax cuts or unpopular offsetting new revenue. A bipartisan approach would circumvent this problem - if sixty votes can be secured in the Senate, tax cuts can be simply financed by debt, in other words, a bigger deficit.
What could be the size of the budget deficit in such a scenario? The US federal budget balance has been steadily deteriorating over the past two years (Chart 4). With one more month to go in fiscal year 2017, it looks like the deficit for the whole year could approach $650bn. Hurricane Harvey and Irma could add $100bn to the budget for fiscal year 2018. If tax reform just adds a couple hundred billion dollars of fiscal stimulus, we could see the deficit in 2018 approaching $1trn.
If this scenario materializes, it would be clearly quite negative for US Treasuries, especially given the increased supply of Treasuries that the market will have to absorb will come on top of those the market already has to take up from the unwinding of Fed balance sheet next year (close to $400bn). Relaxation of financial regulations, another major goal for the Trump administration, could place further upward pressure on rates as US banks will likely be required to hold less liquid assets like Treasuries in the new regulatory environment. What does this scenario mean for the USD? Certainly a combination of looser fiscal policy and tighter monetary policy would be supportive for the USD in the short-term. However, history tells us that a deterioration of the US fiscal position is almost never good for the USD over the medium-term (Chart 5).
An increased likelihood of a government shutdown in December, resulting in rates vol and USD vol set to go up over the next two months.
The fact that Trump pushed to raise the debt ceiling and keep the government funded only until December 15 reinforces our long-held view that the only real lever Trump has over Congress regarding tax reform is his ability to shut down the government (Beware of two games of chicken, July 17). In our view, political brinksmanship may be the only way left to do tax reform and the process will be neither smooth nor pretty. Moreover, as time passes, we think tax reform is becoming increasingly binary. If it cannot get done by year-end, the odds go up that it will never get done as next year is an election year and political appetite for doing tax reform will shrink. The combination of a highly charged political process ahead and the binary nature of the outcome suggest interest rate vol remains too cheap (Chart 6). We like owning vol in the long-end of the curve that would be most correlated with relative safe haven demand and deficit concerns.
In summary: "We believe tax reform is turning into a very high stakes game of chicken with many things that can go wrong between now and December. The upcoming budget process could seriously undo the rapprochement between Trump and the Democrats; House Republicans and Senate Republicans may not be able to reach agreement on tax rates; the White House and House Republicans may not be able to agree on the tax treatment of interest expenses; the Tea Party may try to block any deal that would significantly boost the deficit."
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Tax Reform aside, the other major game of chicken which Woo laid out back in July, and which is still ongoing, is the geopolitical risk as a result of the North Korea "game of chicken." As we showed last week, according to BofA's latest fund manager survey, investors perceive geopolitical risks as the most likely trigger of higher market volatility for the rest of 2017 (Chart 7). And yet, in what appears to be rather frustrating to Woo, "investors do not appear to be in a hurry to act on these concerns", especially when looking at the level of the Kospi which promptly recouped all recent losses and continues to trade just shy of all time highs even as the KRW remains largely unperturbed by the recent geopolitical tensions.
Here is Woo:
Implied volatility and risk premium across markets remain near their year-low. Even those markets that are most directly linked to geopolitical risks shows few signs of panic. The South Korean stock market, which has rallied 18% YTD, is just 2.6% off its year-high. The KRW has risen 6% against the USD so far this year (Chart 8), keeping pace with its Asian counterparts like the SGD and TWD.
This contradiction is puzzling but probably reflects the extreme complexity of the North Korean crisis that is making it difficult for investors to separate the facts from the noise and the true intention of the players from their rhetoric.
While Bank of America says it "does not pretend to know how the crisis will end" it thinks the market does not fully appreciate the significance of two incontrovertible facts that are emerging from the crisis. As a result, Woo is convinced that gamma may be considerably undervalued ahead of an impending North Korean showdown. He explains why below:
1. Sanctions are not working
The two UN sanctions adopted since August have not achieved their intended results. Not only they have not lead to a moderation of North Korea's behavior, they have provoked North Korea into further escalation (Chart 9). Following the UN sanction adopted on August 5, North Korea launched three short-range missiles on August 26, followed by a missile over Japan on August 29, and it conducted its sixth nuclear test on September 3 that experts say was a test of a hydrogen bomb. Following the second UN sanction adopted on September 12, North Korea fired another missile over Japan on September 14 that flew for 3,700 km (a demonstration that it now has the ability to reach Guam).
Why are sanctions not registering the intended reaction? Is it possible that the North Korean leadership has invested so much political capital into the brinksmanship with the United States that accepting a defeat could seriously weaken its ability to rule or remain in power? Turning back may no longer be an option. Given the likely crippling economic impact of the new sanctions (designed to reduce North Korean export by 90% and energy import by 30%), game theory suggests that the North Korean leadership has a strong incentive to bring forward the final phase of the Game of Chicken.
2. China is the only player making concessions
Of the three key players at the table (US, North Korea and China), China has been the only party that has been making concessions. Under pressure from the US, China has agreed to cut coal, iron ore, and textile imports from North Korea and reduce energy exports to North Korea. These concessions, by allowing the US to push through two UN sanctions, have helped calm investors' nerves. The market appears willing to give diplomacy the benefit of doubt as long as the US and China are seen as working together to find a solution.
Developments over the past week suggest China's willingness to make further concession may be reaching its limit. It agreed to support the second UN sanction only after it was watered down. After the North Korean missile launch on September 14, China rebuffed US demand to cut off oil exports to North Korea. China may not want to trigger a collapse of the North Korean regime that for the past sixty years provides a buffer against US troop presence in South Korea. Scholars estimates China lost between two hundred to four hundred soldiers during the Korean War to create the current status quo on the Korean Peninsula.
If China's willingness to give more ground may be limited (even with the approach of its 19th Party Congress on Oct 18), the market is not pricing much in terms of the risk of a deterioration of the US-China relationship. The CNH has strengthened so much this year that USD/CNH is back to early 2016 levels. The option market paints a worrying picture of complacency. USD/CNH risk reversal is at levels we have not seen since early 2014 (Chart 13). Washington has been threatening trade sanctions against China to force Chinese compliance on North Korea. We suspect an escalation of tension between Washington and Beijing would likely be accompanied by CNH weakening (intentional on the part of Beijing or not). Investors who share our concerns should consider buying 3m USD/CNH forward outright at 6.58 (pricing only a 0.5% depreciation of the CNH) or position for a reversal of the risk-reversal.
Putting it together, BofA's analysis suggests that the risk is growing that the crisis - deferred for months - may come to a head in the not too distant future. This flies in the face of the current market consensus that the crisis is likely to drag on, as evidenced by the flatness of vol curves across markets. Incredibly, USD/KRW vol curve remains not only upward sloping (Chart 10) but steep, with 6m implied vol trading at an average premium over 1m (Chart 11).
As such, in the context of the ongoing North Korean "game of chicken", Woo concludes that "The market is clearly not priced for any short-term shock. Investors who share our concerns should consider accumulating short-dated KRW puts or buying KRW gamma against selling long-dated vol (position for curve inversion on escalation)." Finally, Woo still thinks that the JPY would be a beneficiary of any escalation of geopolitical risks. "The JPY's correlation with risk-off has been increasing. We are inclined to fade the bounce in USD/JPY last week after the adoption of UN sanctions. We believe investors should consider taking advantage of any further JPY depreciation before and after the upcoming FOMC meeting to selling USD/JPY. "
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In summary, while the market may now be ignoring, or at least giving the benefit of the doubt to potential adverse outcomes from political risks in the form of both the tax reform process and the North Korean "games of chicken", BofA is convinced that since the "market is clearly not priced for any short-term shock", any adverse outcome could result in a potential risk-off move, one which breaks the market's unstable equilibrium, and result in either a spike in KRW gamma or TSY yield and/or vol.
Will Bank of America be right? With both showdown in Washington over tax reform and brinksmanship over North Korea coming to a head in the coming weeks, we will have the answer very soon.