Geopolitical Developments: Financial Virus Fears Temporarily Dislodge Coronavirus From Top Of Mind

The insecurity of the Chinese Communist Party (CCP) caused financial contagion fears to shake up equity markets across the globe yesterday, but cooler heads helped the US market pick up by close of business. The volatility risk premium is pointing to a range-bound market over the next few days, while my technical reading of key stocks in the S&P 500 is similarly neutral. Besides equity volatility there was one negative factor across global asset classes: copper is pointing to declining global GDP expectations. Expect the S&P 500 to be volatile but range-bound over the next few days.

Contagion fear drove the markets lower yesterday but abated by 3pm EST, suggesting the market will rise today but likely test Monday’s lows sometime later this week. The bears are focusing on shaky Chinese real estate developers and banking on the fact that real estate is a large part of the Chinese economy, both directly (~ 12% of GDP) and indirectly via the national confidence effect and the consumption and investment that flows from rich property-oriented individuals and firms. The fate of developer Evergrande is important also because of cross-default clauses linked to Evergrande that could take other developers down, causing the property sector to plummet. Finally there is the relatively high level of interbank lending across the globe, where a failure of one bank can infect confidence in other banks that have lent to it across oceans. But challenging this scenario is the likelihood the CCP knows all this and has the autocratic levers to force state-owned enterprises as well as chastened private firms to forbear on negative actions resulting from an Evergrande default. And the dominant reason investors are worried about global GDP is the CCP’s manhandling of private firms, which could theoretically be ceased on a dime by Xi Jinping.

The nexus of geopolitical strategies and financial contagion is broad and includes the potential for the US itself to cause contagion because of its highly complex financial markets. The far Left routinely pillories Wall Street and via politicians like Elizabeth Warren, Bernie Sanders and AOC they can cause a panic simply by floating legislative proposals. The biggest sources of contagion risk is via the effect of volatility on exchange traded funds (ETFs) and derivatives markets. Politicians can inflame fears simply by pointing out the fragility of these financial sectors and heavy-handed proposals to shrink their influence.

ETFs could unravel should arbitrage mechanics start to fail because volatile markets move too fast even for the arbitrageurs to execute their hedges. This would be similar to the program trading that felled the stock market in 1987, since hedging failure compounded fears by less-sophisticated investors that the “smart money” was going to have to liquidate. Centralized counterparties like the famed Chicago derivatives exchanges are another huge risk because if one member financial firm fails to make a margin call the CCP is on the hook, resulting in margin trading rules stiffening up and causing investors to fear the worst and liquidate in anticipation.

While the ETF risk remains high, risk.net notes CCP defaults are arguably less of an issue than banks’ exposure to OTC derivatives, and CCP usage has been growing: “Global regulators have been cajoling banks to clear more derivatives for years, but the response has not always been the one they expected. The turmoil that swept the derivatives markets early last year showed it’s in lenders’ own interest to have an extra layer of protection. While investors and companies got hit hard by bouts of Covid-driven volatility, one corner of the market remained unscathed in 2020: central counterparties (CCPs). Despite a few mishaps here and there, no defaults were declared at any major CCPs, nor were their default funds tapped to cover losses from failed members. By funnelling more trades through central clearing, lenders are able to remove an element of risk from the system. And while it’s hard to say to what extent Covid acted as a catalyst for a shift to CCPs, or whether it merely accelerated a secular trend, the latest publicly available figures are encouraging. Data collated by the European Banking Authority shows cleared trades grew as a share of systemic eurozone banks’ over-the-counter derivatives portfolios throughout 2020. The bloc’s eight top banks held €102.1 trillion ($120 trillion) of OTC derivatives notionals at the end of last year, 60.5% of which were cleared. This compares with €55.4 trillion, or 56.1%, a year prior.”

So contagion risk is always real but often overplayed, resulting in buy-the-dip opportunities, such as yesterday around 3pm. I expect another round of contagion-inflected selling to keep the market in its current trading range about 5% off its all-time highs.

Yesterday I pared by short position in the S&P 500 (SPXU) and initiated a long position in the S&P via UPRO. My other current market positions are in Activision (ATVI), American Express (AXP), Amgen (AMGN), Gibraltar Industries (ROCK), Johnson & Johnson (JNJ), 3M (MMM), and Pfizer (PFE).