Trump and the prisoner’s dilemma

Let us assume that Mervyn King is right and the week-toweek strategy of major central banks has become to stop equity markets within their jurisdiction from going down. And let us further assume that markets are fully convinced of central bankers’ resolve to achieve this end.

In the case of US equities, which sit at the centre of the global system, such a proposition logically means that their price has two components: (i) the “intrinsic value” of the underlying shares, and (ii) the implicit promise of support in the shape of the Federal Reserve’s “put”. According to my valuation model-based “guesstimate”, the value of such a put represents 15%-25% of the value of the S&P 500. The implication is that the US equity market is overvalued, if not yet in an outright bubble.

As I have been writing for at least five years, abnormally low interest rates represent nothing but a tax on the poor and a subsidy for asset owners, or “the rich”. This observation is relevant to a certain national election campaign which some readers may have noticed is now cranking up in the United States.

In a remarkable historical role reversal, it is now clear that Hillary Clinton is the candidate for those who have benefited most in recent times from abnormally low interest rates. Hence, if markets become convinced of a Democratic victory in November, little should change and the value of the “put” in supporting asset markets will not be adversely affected.

On the Republican side, Donald Trump’s primaries campaign was based on the premise that he was rich enough not to be captured by the interests of “the rich”, and in another extraordinary shift in the US political firmament, this message was sufficiently well received for him to last week be confirmed as the Republican’s presidential candidate.

In addition to this political calculus, let us assume further that the Fed’s price keeping operation has been done with the help of a few powerful financial houses in the US and some helpful foreign central banks, which have consequently found themselves rather long the US stock market.

Such a grouping must be worried that a Trump presidency will mark a disappearance of the Fed’s “put” since he has expressed support for the “audit-the-Fed” initiative, and so would likely seek new rules regulating the ties between the central bank and financial markets. It follows that such a grouping will face a temptation to liquidate positions (taken to help the Fed in its PKO) should opinion polls begin to favour Trump. I have no particular insight into political matters, but while last week’s Republican convention was hardly glitch free, this is an unusual year as shown by this weekend’s news over hacked emails and apparently inappropriate behaviour in the Democratic National Committee.

Such a behavioural response from those actors assisting the Fed in its grand project would inevitably push the stock market lower, and if this were to happen in a big way, the election of Trump would itself become more likely. For such a group, any indication of growing Trump electoral strength would point to a “heads I lose, tails I also lose” proposition. As such, this amounts to a classic prisoner’s dilemma: so long as the big players do not break rank, the deal should hold but any suggestion that one of them was seeking a jump on the rest and starting to sell could result in all hell breaking lose, and very quickly.

The problem with such pacts is that as soon as one party loses confidence in the ability of all parties to stay together, then the rational response is to be the first one to break rank as such action minimises eventual losses

It will be interesting to watch how the PhDs at the Fed extract themselves from the hole they have dug in recent years. Manipulating markets can work for a while, until one day it stops working and usually the door is too narrow for everybody to get out in time.

I am no speculator, but buying call options on the VIX may be a good hedge against Trump being elected, which may not be the near impossible outcome that serious opinion seems to think. Another approach may be to buy out-of-themoney put options on the S&P 500 which have an expiry in December. After all, the smart money did not see the revolt of the British people coming in last month’s referendum on European Union membership. We are indeed living in very strange times.