Known unknowns

Trump becoming president would trigger a whole new dimension of uncertainty which will last for quite some time

Where will the rupee be in January 2017 if the UK leaves the EU (Brexit, in common parlance) and Trump wins the US presidential election? Going by the most current opinion polls, and suspending any views you might have, each event appears to have a 50% probability. This means that there is a 25% chance that both (or neither) will happen and a 50% chance that one of them will come to pass. Clearly, each event will create a unique kind of uncertainty, which means that till November at least, risk assets will remain under pressure with equities, in particular, remaining soft, with perhaps a few downward lurches till the end of the year. The dollar should be well underpinned; the increasing risk aversion is seen from the fact that the correlation between gold and the euro is at its lowest point since 2010, suggesting that gold and the dollar are trending in the same direction. Sterling is, of course, already showing the strain—it fell sharply at the end of last week as another poll suggested that the Leave camp may win out. Indeed, while it seems nuts to me that the UK should leave—there seem very few positive arguments for it—the truth is that the Leave voters are more passionate and so are more likely to turn out. With the polls so close, this could make all the difference. Indeed, many believe that if the weather is bad—and it has been horrendous in London (at least) recently—Brexit may become a reality. The volatility of sterling has shot higher; relative to that of the euro, it is close to the highest it has ever been. Since the birth of the euro, the average volatility difference has been 1.5%, with the Euro having higher volatility. This is partly because EUR/USD has long eclipsed GBP/USD as the most widely traded currency pair. Today GBP/USD volatility is nearly 2 percentage points higher than that of EUR/USD. The difference has been higher only once before, in 2009 in the wake of the trans-Atlantic financial crisis (as Rakesh Mohan so elegantly defined it). Does this necessarily signal what is going to happen in a couple of weeks? I don’t know, but, if Brexit does happen, sterling will likely fall even more sharply. If it doesn’t, there will certainly be a bounce, but the very fact of the vote, and its likely closeness, will keep the pound and other markets off balance, reflecting as it does the increasing developed world concer ns about globalisation. Companies with significant GBP exposures—large IT companies, for instance—need to have welldefined contingency plans not just in terms of hedging their market risk but also building in the possible future decline in GBP-based business. It is hard to know what will be the long-term impact of Brexit. One view is that it would be limited since the UK is not really a major player in the world economy; on the other hand, there are views that worry that Brexit could be one of the last nails in the coffin of the euro itself, in which case the impact on asset price volatility would last longer. However, the real big “known unknown” is the possibility (increased by yesterday’s mass shooting in Florida) of Trump becoming president of the US. This would trigger a whole new dimension of uncertainty in markets, which will last for quite sometime, since Trump appears congenitally unable to curb his foolish tongue. Nobody will know what to expect with the possibility of another verbal bomb at any time. Markets will be compelled to start pricing risk higher, which in itself is no bad thing, given that it has been so badly underpriced for so long. Likely as not there will be a huge swing in the other direction—to overpricing risk—which may finally end the incomprehensible era of negative yields. The bad news is all this will certainly exacerbate the weak global economic situation. On Brexit, the rupee, like all other risk assets, will take a hit. India’s relative attractiveness may limit the impact, particularly if that other “known unknown”—Rajan remaining as RBI Governor—turns out positively. My personal view is that he would be keen to remain governor, if for no other reason than to responsibly ensure the orderly settlement of the FCNR repayment, which falls due right after his renewal (or retirement) date. His style and recent comments also suggest that he is going nowhere right now. On the other side, it is hard to believe that the government, which is currently doing so well— at least in terms of global public relations—would want to rock the boat for no real reason. However, come November, if Trump succeeds, no amount of global attractiveness will protect the rupee (or anybody else). While globalisation does need to be calibrated, Trump’s approach is likely to strangle growth. Protectionism will rise as will the dollar and global volatility. Thus, any bounce in the rupee if/when Rajan is confir med to stay on should be used as an opportunity to reduce short dollar positions by at least 50%, unless, by then, Trump has started collapsing in the polls. Actually, as I think of it, buying options (in almost any asset) today would be a great trading strategy.