by Peter Spence at The Telegraph
Two words are back on the lips of every investor in the City.
“Event risk” has begun to dominate trading floor conversations, as a slew of central bank decisions, legal rulings, and political upheavals threaten to bring an end to the calm that has descended upon the markets.
After a brief break from the turbulence that dominated the start of the year, when fears over the strength of the global economy and the idea of a sharp slowdown in China unnerved money managers, volatility is set to return to the scene.
Mellow May is now expected to give way to what industry veterans are already calling “flaming June”, as a calm start to the month is to be followed by shifts throughout currencies, stocks and bonds.
Experts say that they expect June to be a “big month” for the markets, and that things are unlikely to settle down any time soon.
Investors will face an alarming number of binary events – those with only two potential outcomes – between now and July.
The most important decisions will be those made by policymakers in the US, on whether to raise interest rates, and votes cast by the British public, on the UK’s continued membership of the European Union.
Also on the schedule are the Spanish general elections, where voters could reject austerity imposed upon them by Brussels, and the potential for radical new monetary stimulus from the Bank of Japan.
None of these events can be discounted, and every one is difficult for investors to prepare for.
Take, for example, the coming ruling of a German court on one of the measures introduced by the European Central Bank during the depths of the eurozone crisis.
The tool – part of a pledge by Mario Draghi, the ECB President, to do “whatever it takes” to preserve the euro – is controversial in some German corners, despite never having been used.
The Outright Monetary Transactions programme (OMT) would have allowed the ECB to buy unlimited amounts of debt from an embattled European government, a promise that helped to restore faith in the eurozone.
However, the German constitution forbids transfers from German taxpayers to other governments. If the Karlsruhe-based court does rule against OMT, then it could undermine confidence in the kind of economies that the programme was designed to support.
Justin Knight, a UBS strategist, says that he doubts that a ruling against OMT would have a sizeable market impact. Peripheral bond markets are in a much stronger position than they were in 2012, and countries have adopted meaningful economic reforms since.
However, Knight admits that he can not be certain of the market outcome, as “of course you are never 100pc certain”. The German decision, due on June 21, is just one moment in a month with a “particularly high” number of risks that could upset the recent stability of financial markets.
Navigating stormy waters
Marchel Alexandrovich, a Jefferies economist, says that the stability in markets is unlikely to persist, rather, “May is the one calm month we have before a pretty volatile June”.
Navigating the various pitfalls June presents will require markets to take each event as it comes, while maintaining an awareness of how each outcome will tilt the balance in the decisions to come.
Alexandrovich says that markets will “almost have to sit back and watch how events unfold”.
The first for them to process is the Federal Reserve’s meeting on June 15. While dreadful US hiring figures have deadened anticipation of a rate rise this month, the testimony of Janet Yellen, the Fed chair, will shift expectations for a move in July.
If the central bank does raise rates this summer, or if it does not, then there will be “an element of surprise”, says Alexandrovich.
Market pricing suggests there is almost a one in three chance that the Fed makes a move over the next two months. Some investors will be gambling on the possibility. An increase in rates would favour them, but mean that others would have to adjust their portfolios swiftly.
The dollar would rise, and concerns would turn to emerging markets, which would be likely to struggle, given that they have gorged themselves on cheap debt since the Great Recession.
The move could reignite the concerns that rocked markets at the beginning of the year, when investors considered the possibility of another global downturn a very real threat.
A decision not to raise US interest rates may be little better. Again, a large subset of money managers will be caught off guard. In this instance professionals may question the Fed’s reasoning for not making the move.
Traders could take reluctance to press on with a quarter percentage point increase in rates as a sign that the Fed has lost confidence in the US economy.
“That would not be a particularly calm outcome either,” says Alexandrovich.
Once the Fed’s meeting is out of the way, the Jefferies analyst says that markets will turn to the EU referendum on June 23. This vote would not just have repercussions for the UK, but for the whole of Europe, he adds.
“It potentially has a big impact on the elections in Germany and France next year, and will mean more attention on the extreme parties in those contests.”
Almost straight after the Brexit vote, investors will have the Spanish general election on June 26 to contend with. The last elections, in December, resulted in no government being formed, and pundits believe there is a decent chance that anti-austerity parties make inroads at the ballot box this month.
In Japan, officials may decide to deploy “helicopter money”,government spending stimulus funding by central bank printed money. Experts believe that the Bank of Japan could unveil the policy on June 16 in their fight against deflation; deploying a tool unseen in the modern era, and one economists may struggle to anticipate the full effects of.
Investors stuck without options
Unlike most events that investors have to process, these binary events are much more stressful. Kit Juckes, a Societe Generale strategist, says that everyday economic statistics are far easier to process.
“With a piece of data that is a little stronger or weaker, you move your position a little more,” he says. Yet with discrete events, like elections, no such option is available. There are only two possible outcomes of an ‘in’ or ‘out’ referendum, like the coming June 23 vote.
Juckes says: “If you’re convinced that one of the outcomes is very difficult, that is very hard to work with.” With the outcome of the EU referendum still far from clear, it is difficult for investors to know how to hedge themselves.
In normal times, this might not be so troublesome, says Juckes. Yet with interest rates around the world practically flat, and sub-zero in places, investors are having to take much greater risks in order to deliver returns for clients.
This world is one of “risk on, risk off” behaviour, where, when the world is quiet for five minutes you own riskier assets in order to make some kind of a return, and when it gets scary again, you have to scarper, the strategist explains.
Money managers have to “either put up with really poor investment returns, or they take what they might once have thought were disproportionate risks”, says Juckes. They are walking across a rickety rope bridge, he says, with danger on either side of it.
“On one side is the fear that the global economy slows so much that we have huge concerns about emerging markets and on the other side is that interest rates can’t stay down here forever, and, particularly in the US, rates have to go up.”
As a result, Juckes says that markets have become “hypersensitive to this sort of random, idiosyncratic event risk”.
The threat of a sudden slowdown in China, oil prices moving up or down sharply, or perhaps even the collapse of the Brazilian government right before the 2016 Olympics are set to begin in Rio are all risks that could upset the balance.
For portfolio managers, the correct response may be to sit out some of June altogether, says Alexandrovich, who believes that the “logical way to approach this uncertainty is to basically take risk off the table” and avoid holding eurozone periphery debt. Juckes says that markets will have to “feel their way through” these events.
It’s the politics, stupid
On the surface, the various risks that approach this summer may look unconnected.
However, the increasing political fragmentation in Europe is starting to look related. Growing support for parties of the right in northern Europe, and forces of the left in the south “have the same original provenance”, says Knight.
The spread of populism has travelled beyond the European continent. The rise of Presidential hopeful Donald Trump across the Atlantic threatens to frighten investors, even if the summer brings only minimal jitters.
This year’s White House race will come to a climax in November. If Trump faces off against Democrat candidate Hillary Clinton, as is expected, the real estate mogul’s views on the US debt – suggesting he could renegotiate government obligations – could undermine the global status of the dollar as a safe haven currency.
The former reality TV show host has even gone so far as to suggest that the American government could print money to avoid default.
Most are economists, mathematicians or physicists by training, Knight explains, and while they might understand economic statistics very well, and are able to fluently speak the language of models, yield curves and price to earning multiples, “the world of politics was largely foreign to them”.
While investors have improved their understanding, Knight says that this area “is still not their field of expertise”. It is hard to apply scientific techniques to understanding how the minds of voters change, making it “much more difficult” than economics 101.
For policymakers, just as much as traders, playing guessing games with how June will pan out is likely to affect their decisions.
Central banks as well as hedge funds have had to bring in political experts, think-tanks and academics to garner insight into a field once alien to them.
Fed officials have said that the uncertainty around the Brexit vote could affect when they decide to raise rates. Similarly, a UK decision to leave the EU could affect a decision to implement a financial transactions tax, a verdict on which is due by June 30. Westminster has fiercely opposed such a measure, which would see a charge levied on the sale of shares.
Looming over each of these individual events is the as-yet- unresolved question of China’s economic stability. The world’s second-largest economy, which has struggled with funding crunches each June since 2011, is still thought of as being in a vulnerable state.
Societe Generale believes that there is a 30pc chance of a “hard landing” in the coming year; a rapid slowdown in the Chinese economy could easily derail the wider global economy.
Juckes says that this year reminds him of the last, when worries about China cooled between February and July, and then kicked off again, climaxing on Black Monday in August.
“It feels to me as if you can’t destroy the energy in markets, but you can bottle it for a while,” says Juckes. “If you shake it it can all go a bit wrong. We aren’t necessarily going to take the top off of it in June, we may navigate through.
“But the hardest thing is to guess how long that volatility can stay bottled up. Calm isn’t a sign that everything is OK.”