This is a brief follow-up on the last post I wrote about how markets aren’t freaking out about the Trump scandals. I wrote that “this is only one day. What is happening with Trump – while negative – will not change the arc of the US economy and markets.” And we see that this is true today, as markets have bounced back despite more revelations and a corruption scandal that is punishing Brazilian assets.
Now, even people like former Fed chair Ben Bernanke are puzzled as to why markets ignore political risk. I talked about political risk back in March as basically ‘unhedgeable’ due to Knightian uncertainty – which is a risk that is immeasurable or incalculable. In effect, political risk is never fully baked in until it materializes because the hedges are too expensive relative to risk. An example is the risk of Italian redenomination or default. Yes, the spreads are somewhat elevated but until it really happens, how much money are you going to put toward hedging that risk? How much time are you going to spend worrying about that? I’m guessing not a ton – that is until the risk is palpable.
But even if the political risk is crystallized, we can’t know what the actual economic and market consequences will be. Look at the Brexit referendum, for example; everyone was telling us it was going to be a complete economic disaster and that Britain was going into recession. UK bond yields were supposed to skyrocket. That didn’t happen; yields plummeted to record lows. Or how about 9/11 and oil? When the US invaded Iraq in the first Gulf War, oil prices spiked. So you would think that the prospect of a second war would mean the same thing. Instead oil prices tanked.
Bottom line: if you care about markets, look at the economy, earnings and interest rates. That will tell you a lot more than politics.
I talked a bit about this – and about the actual politics – on CBC’s ‘On The Money’ show. Here’s the clip, with my part starting in right near the beginning (link here).