On Trump, risk and uncertainty

As if Donald Trump’s tribulations were not bad enough, we learned today that Brazilian President Temer has been caught on tape endorsing bribery payments. The net result was that Brazilian financial markets took a hammering with the equity market opening 10 per cent down, which triggered an automatic halt in trading, whilst the currency wiped all its year-to-date gains. This comes a day after US – and by definition global – markets suffered heavily in the wake of mounting disquiet regarding the conduct of President Trump.

Without making any comment on the rights and wrongs of their respective actions, what is most fascinating was the market response which has been extremely negative. We should not overlook the fact that the VIX index – a measure of option volatility on the S&P500 – was at 24 year lows at the start of last week. This index is often referred to in the financial press as the “fear index” because the extent to which volatility changes is associated with changes in market sentiment. As it happens, this is a little misleading because the VIX is a measure of market perceived volatility in either direction. But a surge from a low below 10 last week to above 15 today is a measure of a market which is nervous.

What has struck many investors as odd over recent months has been the extent to which markets have been able to shrug off the uncertainties in the wake of Donald Trump’s election, driving US equity indices to record highs and volatility to multi-year lows. The surge in prices has clearly been driven by expectations of the Trump reflation trade. But as I noted at the start of the year, “I suspect markets will not get the benefit of the hoped-for fiscal stimulus” and I still stand by that view, primarily because the president’s difficulties will make it much harder for him to drive through his economic agenda. Predicting that markets will correct is a mug’s game but in the absence of a tailwind from expectations of stronger growth, it might be harder for equities to make big gains from here, particularly when valuations are already high and the Fed is raising rates.

Last week’s interview by The Economist of the President, which resulted in a scathing assessment of Trumponomics, did not fill me with much hope that a growth plan is forthcoming. The Q&A transcript struck me as a rambling and superficial overview of his plan. However, none of this should have come as any surprise. So it always felt strange to me that markets could be so sanguine and, despite the fact we are living in some of the most extraordinary economic times in recent history, that equity volatility could decline so far.

This supports the view which I have held for many months that whilst markets can price risk they cannot price uncertainty, and as a result have simply given up trying to do so. This difference between risk and uncertainty is a long-held tenet in economic and financial circles and stems from Frank Knight’s 1921 book “Risk, Uncertainty, and Profit” which made a clear distinction between known unknowns and unknown unknowns (long before Donald Rumsfeld picked up on the concept). It does go a long way towards explaining why markets can suddenly switch from a stable state to an unstable one. In the wake of both the Brexit referendum result and Trump’s election, markets realised very quickly that sharp sell-offs were unnecessary and that there was potential for a rally. Investors knew full well that it could all go wrong but probably rationalised the view that there was no point in waiting for the other shoe to drop. Far better to ride the cycle on the way up and deal with the consequences of the sell-off as and when it happened.

But just as many of us failed to pick up the tail risks last year, so investors have to beware the possibility that these risks begin to manifest, perhaps in the form of no Trump reflation trade. If we can’t price uncertainty, then maybe investors will be forced to pay more for risk protection. That alone might take the edge off the recent US rally. Of course, it may not, but if and when the correction finally does occur, it could be all the more painful.