Playing the Waiting Game
Since the post-Brexit rally in late June through early July the market has gone sideways presumably waiting for greater clarity on the election and what the Fed will do with interest rates in December. The current view is that interest rates will be hiked 25bps from the current range of 25-50 bps by Christmas based on recent data from the CME FedWatch:
Source: CME FedWatch
How will election affect the markets? One word -> Volatility
Meanwhile, despite the highly entertaining presidential debates and drama surrounding Donald Trump, Hillary Clinton currently is predicted to have a high probability of winning the election according to FiveThirtyEight:
The consensus has been that a Trump victory would lead to short-term volatility, and it appears that the odds of this happening are rapidly shrinking. However, it is likely that investors will hold on to their excess cash reserves until the election has been finalized. This makes the market somewhat attractive from an early entry standpoint.
Another factor that has contributed to recent volatility have been a “flash crash” in the British pound which plummeted more than 6% overnight in a two-minute span last Friday. No one knows for sure what the cause of the precipitous drop in the pound actually was, and some pundits are once again claiming that it was a “fat finger” trade. Given that the pound continues to flag, the consensus is that strong nativist talk by the British PM against compromising on immigration policy is putting the UK at odds with the ECB- which increases the chance of a UK exit. No one knows what will happen regarding the Brexit but we estimate that this will be a long and drawn out process that will gradually be discounted into the market over time. It is reasonable to believe that the currency markets will continue to reflect any volatility caused by Brexit proportionately more than the global stock markets.
Meanwhile there are also concerns over the fate of Deutsche Bank whose stock price has been under pressure with a looming settlement fine with the US Department of Justice. The current demand from the DOJ is that Deutsche Bank should pay $14 billion for their role in trading mortgage bonds during the credit crisis. Given that Deutsche Bank has already fallen short on capital stress tests, the large settlement value puts their solvency at risk to some degree. Considering that Deutsche Bank is Europe’s biggest investment bank it is one of the largest contributors to systemic risk among large lenders. The chart below shows how important Deutsche Bank is within the global risk complex:
Source: IMF via ZeroHedge
There is room for optimism regarding Deutsche Bank: much of the capital shortfall for Deutsche Bank can be attributed to stricter capital requirements from global regulators designed to avoid a repeat of the taxpayer funded bank bailouts of the 2008 financial crisis. In other words, they are deficient according to much stricter and more conservative criteria. Furthermore, given their importance to global systemic risk, it is logical to believe that the DOJ will attempt to moderate the fine to a level far below the current demands. Finally, since Deutsche Bank is Germany’s most important bank it seems highly unlikely that they will allow them to fail without providing support.
We are currently playing a waiting game as some of these fears are absorbed and digested by the market. Considering that the market has already priced in an interest rate hike to a large degree along with a Clinton victory, and that the systemic risks posed by Deutsche Bank and Brexit may be transitory, we may be setting the stage for a considerable year end rally. Of course it is entirely possible that these problems become more permanent and that father time will end up catching up with this bull market. In either case we stand prepared to adapt and respond accordingly.
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