Markets sensitive to political volatility

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North Korea’s desire to become a nuclear power and indeed its recent fast-paced march towards this goal has brought a new dynamic not only on the political arena but also to the world’s economy in the last few weeks.

Daniel Ngwira

North Korea argues that its quest to be a nuclear power is meant to protect the country from hostilities. Several missile launches have proved that North Korea has remarkably perfected its expertise.

Indeed, the country’s leader Kim Jong-un claims that they now have missiles which can reach any part of the United States mainland. This has made the US and its allies uneasy.

In an unprecedented move, the United Nations Security Council unanimously passed a resolution to slap North Korea with sanctions, which would potentially curtail export earnings by a third.

This essentially means that both Russia and China voted in favour of the United States-crafted sanctions resolutions. Despite this, both China and Russia emphasised that it was paramount for discourse to supersede military intervention.

While a pre-emptive military attack on North Korea by the US seems unlikely given the impact of North Korean retaliation on US allies which are in the Korean peninsula, an attack by North Korea could leave the US with very little option but to retaliate to safeguard its interests.

In the subsequent days following the vote to slap North Korea with sanctions, a war of words ensued between US President Donald Trump and North Korean leader Kim Jong Un.

The support of sanctions against North Korea at the UN Security Council by China is seen as a game changer given that China is perceived as holding the lifeline of the North Korean regime as it is the major trading partner.

The height of this tension came in when Trump said if North Korea continued to threaten the US, it would be met with “fire and fury and frankly power, the likes of which the world has never seen before”.

This angered the youthful North Korean leader who further went on to threaten to fire missiles on Guam, a US pacific island.

The North Korean leader threatened firing missiles on Guam by mid-August.

Guam is home to US military base and over 160 000 US citizens. It is no coincidence that North Korea singled out this island as a target.

In essence, Guam is US soil, though citizens in this part of the island do not vote in US elections. Over 30% of the economy is military-based. It is within North Korea’s reach.

It is home to Anderson Air Force Base which North Korea views as having played an “intimidating” role each time the US tries to show its military might to the North Koreans, usually following some missile launches.

As the war of words between the two leaders ensued, markets reacted furiously with the “fear index,” (as the VIX is informally known) jumping 44% to 16,04, still below the red line of 30 despite the rising geopolitical tensions). VIX measures volatility.

Volatility is a measure of market uncertainty. It is understandable that the markets reacted this way as both Trump and Jong-un are not well-known for predictability. The Chicago Board Options Exchange (CBOE) volatility index (VIX) measures market’s expectation of volatility. It is constructed using the prices of options on the S & P500. An estimate is then made of how volatile the options will be in between the current date the expiry date of the options. In many market pricing situations including the pricing of options using the Black-Scholes model, volatility is a key input in the computation.

Fear, which is measured by volatility, is a very important factor of pricing and therefore values. When investors are scared, they run with their money because in the first instance the safety of an investment is considered paramount. That is the reason why even when returns are fantastic, as long as incertainty is too high to bear, investors will make a choice to invest elsewhere. In markets where investors’ fear is not measured by an index, a substitute will be to use the stock market index. However this is not as accurate as a volatility index.

For instance, there are many reasons why stocks may be sold; id est to fund key expenditures like school fees, Christmas holidays and quarterly payment dates for taxes to the Zimbabwe Revenue Authority.

Whereas the stock market tells a story about bulls running or bears prevailing, it is not sufficient to tell the reason why there are bulls and bears in the market, neither can it quantify the level of fear in the market. This is unlike a volatility index in the form of the CBOE VIX where values higher than 30 imply significant volatility while values lower than 20 imply less volatile situations which can be translated to good times in terms of stability. Thus the volatility index is a measure of confidence. It has been stated by both fiscal and monetary authorities in Zimbabwe that the level of business confidence is very low. While this is an agreed position, the level cannot be quantified without a form of index or determined measure.

The VIX is not the only market indicator that reacted to the tension between the US and North Korea. The dollar traded weaker against major currencies like the British pound sterling and the Japanese yen. This happened as investors dumped the greenback to hide into gold and silver. As a result, the gold and silver prices edged higher due to investors stampeding into them and away from the dollar. The dollar is traditionally seen as a safe haven by investors given the robustness of the US economy.

However, with the US and North Korea apparently on brink of war last week, investors saw cause for them to look for alternatives.

Across global markets indicators were in red. This included the South Korean stocks as measured by the Kospi, Asian markets led by the Nikkei in Japan, the Hong Kong Hang Seng, the Shanghai Composite in China. European markets were not spared either. This is as investors expressed disapproval with the war of words between the world’s super power and North Korea, a country which has for long felt isolated by the international community save for the support of China and Russia. North Korea’s vendetta with the US dates back way in history.

The political noise between the two leaders interrupted the nearly two week momentum of the Dow Jones. As a result, the Dow traded lower as the markets became uneasy with the then ongoing tension. Since Donald Trump became president of the United States, the Dow has been reached record levels peaking at 22,000.

This has been on the back of the perception that the Trump victory was good for the US economy considering that the President promised to trim bank regulations in the Dodd Frank Act. This would see banks lend more and thus make money through their core business of giving loans.

Increased credit creation would propel the US economy, ceteris paribus. The Dodd Frank Act was put in place by the Obama administration as a reaction to the excesses of little market regulation which culminated in the global financial crisis.

Trump believes well deserving people and businesses are being denied credit because of the regulations. In the process, he argues, economic growth is affected negatively.

In addition, Trump promised and continues to promise tax cuts especially for the corporate world. Investors see this as a positive move as lower taxes will result in higher earnings for the corporate world.

This is essentially what has resulted in the Dow breaking its own records in terms of the highs.

As the tension between the two countries was reaching dangerous levels, the Chinese President called his US counterpart and urged restraint. He emphasised diplomacy in resolving the crisis over military option. Indeed many advisors in the US seem to concur that military action is not the best option. As tensions eased, markets rebounded as investors felt rather comfortable that the situation would unlikely degenerate into a conflict.

Yet the North Korean saga was not the only headache for President Trump. The hate group’s rally in Charlottesville, Virgini-Zanya turned violent. Trump’s speech on the incident was viewed as inadequate as he did not categorically denounce what was considered to be white supremacy.

This drew criticism from a number of people including Kenneth Frazier, the chief executive of Merck pharmaceuticals who in a statement said that “America’s leaders must honor our fundamental values by clearly rejecting expressions of hatred, bigotry and group supremacy… as a matter of personal conscience, I feel a responsibility to take a stand against intolerance and extremism.”

Trump subsequently issued a revised statement. Still this was not well received in some quarters as it was seen as damage control rather than something that came from his heart. Critics drew comparison that it took two days for Trump to comment on the violence whereas it took just under an hour to respond to Frazier’s resignation from the Trump’s American Manufacturing Council. Trump blasted the pharmaceuticals CEO in a tweet in which he said that Frazier “will have more time to Lower ripoff drug prices.”

There is something to learn from these developments. Firstly businesses have an undeniable duty to their shareholders.

What Frazier is trying to run away from is what is called association risk. Trump is seen as a divisive character.

In business, ethics is now one of the cornerstones of survival. Businesses seen to be unethical face the risk of losing customers and investors and thus affecting their long term survival.

Secondly, politicians should be sensitive to business needs given that they pay taxes for the good of the entire country. Despite criticizing Frazier, Trump issued a revised statement after Frazier distanced himself from the White House. This is a strong indicator that business and people’s interests rule in America. The revised statement by the American President specifically denounced the far right groups by name. This stance by the President should not been seen as a weakness but leaders from other countries should learn from this; leaders are meant to serve the interest of the people.

Finally, it should be noted that the political developments in and of any country have a bearing on the economic developments. In the short turn, approval or otherwise of political decisions can be seen through the equities, currency and other markets which react swiftly to any meaningful developments that occur in the environment.

In the long term, disapproval of a country’s policies or political rhetoric will come through as increase or decrease of foreign direct investment. Zimbabwe has been struggling to attract foreign direct investment in recent years, with the central bank reporting in the mid-term monetary policy statement that foreign investment receipts took a 79,27% nose dive to US$6,8 million in 2017. This can be attributed to fear by the investors of Zimbabwe as a destination for their capital. Yet Zimbabwe remains stuck in its ways when it can improve its fortunes by doing things differently.

Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. — daniel.ngwira@gmail.com/ cell: +267 73 113 161.

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