Shadows of the Financial Crisis Loom Large over Markets

Government intervention in markets, and market developments that force political responses, are keeping risks high and macro traders glued to their screens.


It’s not just Hank Greenberg’s lawsuit against the government over its takeover of American International Group that continues to reverberate a full seven years after the 2008–’09 global financial crisis. Hedge fund traders and portfolio strategists still see markets as being shaped by the panic of the crisis and the ad hoc policy responses to it — both the short-term liquidity injections by governments and central banks and the long-term floodgates of quantitative easing.

Decisions made (or sidestepped) by governments in the wake of the crisis loom large in traders’ predictions for the remainder of 2015. In general, they see low growth in the euro zone, sans Grexit; slowing growth in China (with some official fudging of the figures); solid expansion in Japan; a shuffling of the Titanic deck chairs occupied by the Fragile Five emerging markets; a cautious reversal of quantitative easing and normalization of rates in the U.S. and U.K. even as central banks in the euro area, China and Japan continue to flood markets with buckets of money; a slightly less dangerous world notwithstanding continued chaos in the Middle East (the Iran deal excepted) that leaves Brent crude swinging in a $50- to $70-a-barrel band; and, last, systemic risk lurking in the financial plumbing as a result of a potential lack of liquidity. In short, politics matters more than ever.

It’s hard to forecast these political decisions, though, because the arrow of causality between political and market risk may have reversed. “I posit that the directionality between the two has flipped over the past decade,” says Laurence Zuriff, general partner of New York hedge fund ZFI Capital. “During the cold war and up until the global financial crisis, political risk contributed to market risk. Political incidents roiled and disrupted markets, causing price dislocations that took a long period of time to adjust. Today it is the reverse. Macroeconomic disruptions are having a profound effect on politics.”

Conventional political risk analysts spend a lot of time figuring out how political events move markets in general and how political and economic events affect specific asset prices, ranging from individual stocks or commodities to an entire portfolio. Figuring out how macro market developments move politics is much trickier because there are multiple pathways from markets into politics, from fiscal austerity to inflation to high unemployment, each of which has different distributional consequences.

Consider the case of Greece: The absence of contagion from Athens’s troubles to euro zone markets generally emboldened Germany and like-minded Northern countries to hold a firm line in recent bailout negotiations, and the meltdown of the Greek financial system caused Athens to blink and defenestrate Yanis Varoufakis from the Finance Ministry.

In a survey of three dozen macro traders and strategists conducted in mid-June, before the July 12 agreement in principle on a third bailout, respondents put the risk of a Greek exit from the euro at 35 percent, up from 23 percent in January. Even so, a two-thirds majority maintained that a compromise would be hammered out and that Greece would remain inside the euro zone. With the actual bailout program still to be negotiated and some key players, including German Finance Minister Wolfgang Schäuble, still casting doubt on the merits of the July 12 deal, there’s plenty of room for those numbers to shift.


Back in January, Wolfango Piccoli, director of research at risk consulting firm Teneo Intelligence (which I chair), correctly predicted that Schäuble and his chancellor, Angela Merkel, would hold firm and ultimately bring the Greeks to heel. “The German government is bracing itself for a prolonged standoff with Athens, especially as many in Berlin believe that time is on their side,” he wrote at the time.

In the wake of the July 12 deal, Piccoli is sticking to his guns. “Prime Minister Alexis Tsipras’ early exit from office is still more likely than Grexit,” he says. “Our baseline scenario is that Greece will return to the polls before the end of the year. Syriza will split when its congress meets in early autumn, a development that is likely to pave the way for snap elections before year-end. As for the bailout, there is little chance that a Syriza-led government will succeed in implementing the required reforms and meet the relevant targets, meaning that the autumn could see another confrontation between Athens and its euro zone partners in relation to the thorny matter of debt relief. Significant levels of political volatility are here to stay in Greece.”

“The euro crisis is not over,” agrees my old friend John Greenwood, chief economist at Atlanta-based asset manager Invesco. “The fundamental flaws at the heart of the design of the euro zone are again clear for all to see. Without a political union to underwrite a federal euro zone and its banks, or member states and their banking systems, the current monetary union will be vulnerable to recurrent crises. The time has come for the euro area’s leaders to face up to the decision to either accept Greek default and Grexit or create a political union that is financially strong enough to underwrite the debt of any entity within it. It makes no sense to continue with the pretense that the European Stability Mechanism, the banking union or the reliance on member states obeying fiscal rules are anything other than the euro area equivalent of ‘extend and pretend’ central bank policies.”

Watching economic-political linkage play out in Greece has been gripping, but it is equally at play — and on a much larger scale — across almost all emerging-markets countries. Anticipation of the first Federal Reserve tightening move and a return of rates toward more-normal levels has triggered billions in portfolio capital outflows from emerging markets, inducing foreign exchange volatility and amplifying an often already-fraught political landscape.

The January survey assigned 50-50 odds of a major emerging-markets financial crisis in the first half of this year. So far, no emerging-markets banking system has actually melted down, although Venezuela’s foreign exchange system is so convoluted that it’s hard to tell just how bad things really are. The de facto devaluation and associated shortages and queues in every major city suggest that the Bolivarian Republic has been in a severe financial crisis for at least the past six months.

In the June survey traders assigned to Ukraine the unenviable distinction of being the most probable emerging-markets country to default, followed closely by Venezuela and Argentina. Brazil and South Africa have swapped places, with Brazil now No. 4. Survey respondents also markedly increased the likelihood of large-scale violence in Ukraine and social unrest in both Venezuela and Brazil.

The collapse of commodity prices has dimmed the macro prospects of all five countries. Venezuela is in the sharpest pinch because of the plunge in oil prices. Ukraine, Argentina and Brazil are all on the wrong side of the drop in agricultural commodities while Kiev, which is now trying to negotiate debt relief with its creditors, is under strong pressure from Russia. Our traders put the risk of default at 1 in 5.

Survey respondents assigned 1-in-3 odds of more major violence in eastern Ukraine, a curiously bloody kind of “frozen conflict.” As a New York–based emerging-markets trader puts it: “Putin’s near-term goal in Ukraine is to freeze the conflict. I don’t believe he currently has greater territorial aspirations in Ukraine or elsewhere. Putin wants to consolidate Russian influence, and he correctly assumes that Ukraine will not become part of the EU or NATO. Putin also believes that the resources required to rebuild Ukraine into an effective state following the conflict and the breakdown of civil order are substantially more than the West will be willing or able to pay.”

The economic vise on Caracas and Moscow isn’t loosening any time soon. Our survey places a 55 percent average bet that Brent will maintain a trading range between $50 and $70 a barrel through the rest of this year. According to research by Citigroup’s global head of commodities research, Edward Morse (my thesis adviser at Princeton University in his much younger days, and mine), that range is painfully below Venezuela’s fiscal break-even oil price of $151, Iran’s $131 and Russia’s $107.

The average bet that Brent will trade below $50 is just 22 percent, based in considerable measure on the June survey’s more optimistic 40 percent odds that Iran would successfully conclude the nuclear framework agreement with the U.S. and other members of the P5+1 group (which it did in mid-July) and that ISIS’s bloody war won’t impair Iraqi output.

The average bet that Brent will trade above $70 is almost the same, at just 23 percent, despite greatly increased fears that ISIS contagion will spread beyond northwestern Iraq. The survey’s contagion odds are now 80 percent, compared with 55 percent in January. But such contagion does not mean that ISIS is shutting down Iraqi oil production. To the contrary, ISIS has been selling about half a billion dollars a year of oil on world markets, according to a back-of-the-envelope estimate by the U.S. Treasury’s assistant secretary for terrorist financing, Daniel Glaser.

“There was global demand growth of 1 million barrels per day being more than offset by global supply growth of 2 million barrels per day,” says a New York–based commodities trader. “So the market got ahead of this overcapacity and the price of oil collapsed even as ISIS was approaching Baghdad. When Obama said he wouldn’t let Baghdad fall, that was the day of the top of the oil price. Since then oil inventory has been increasing significantly.”

Whether this political calculus will contain Brent in the $50 to $70 band much beyond December 2015 is unclear, with several traders guessing that excess inventories will disappear quickly once global growth kicks in. “Already, the market is looking ahead again,” muses the same commodities trader. “North American production is likely flatlining and will slightly decline into the end of the year. Demand growth is picking up. There will be 1.5 million barrels of demand growth going forward, with flat North American production, which will together quickly reduce inventory levels. So I believe we are looking at a ripping bull market again before too long.”

ISIS may not have captured the biggest oil fields in Iraq or interfered much with production in southern Iraq and the Kurdish north, but as a source of regional contagion, including into Jordan and quite possibly Saudi Arabia, the self-styled caliphate isn’t going away any time soon. “The real threat is not about numbers of current fighters — 37,000 — but the strength of their ideology and the sense of a mission set against Western purposelessness,” said Graeme Lamb, former commander of the U.K.’s Field Army and an expert in counterinsurgency, at a May gathering of traders and strategists at Ditchley Park, a stately manor in Oxfordshire. I observed General Lamb in the field in Iraq and Afghanistan, and I know he’s a thoughtful analyst of both the political and military balances in the region.

“I don’t look at security as the key metric; I look at stability instead,” said General (now Sir) Lamb. “There is tremendous instability in the Middle East. I think refugees and internally displaced persons are the disruptive wild card in the region. The Red Crescent is putting a finger in the dike, but no one is building a dam. There are millions of refugees getting no education, health care or vocational training; life is utterly hopeless for them. This is a Hobbesian world on steroids. It will result in a great melting pot of blame.”

Of course, there’s plenty of blame to go around for Syria’s breakup, not the least being Iran’s direct support of the brutal Assad regime and its indirect support of Assad through its Hezbollah proxy. The Iranians blame the Saudis for Sunni extremism, and the Saudis accuse Tehran of covertly supporting the Houthis in Yemen and Shia separatists along the Gulf, including Saudi Arabia’s restive eastern provinces.

And in one of history’s recent ironies, the Israelis and the Saudis both blame the Obama administration for the nuclear framework deal with Iran. As Prime Minister Benjamin Netanyahu’s spokesman Mark Regev said in an interview on CNN, it takes a lot to put Benjamin Netanyahu and the House of Saud on the same page.

“I suggest that a nuclear deal could be a quid pro quo for allowing Iran’s Revolutionary Guard to lead the front against Islamic State,” says Michael Hintze, founder and CEO of London-based hedge fund firm CQS. “It may not only be on nuclear but also enable Iran to export its oil. Consequently, I believe there will be more downward pressure on the oil price, and there is even more downside risk to Brent than West Texas intermediate.”

China may be the clearest case where macroeconomics is moving politics, and where the political decisions in response to market developments are both heavy-handed and cloaked in secrecy. The Chinese financial authorities’ blunt interventions to stem the implosion of the country’s stock market have reinforced the assumption of our traders and portfolio strategists that Beijing’s command economy instincts take over when markets get too volatile.

Back in January most of our survey takers believed China would register GDP growth of 7 percent in the first half of 2015. As one skeptical trader quipped, “If President Xi Jinping and Premier Li Keqiang want 7 percent, they’ll get it no matter what happens to China’s real economy.” And that’s exactly what happened: The China national statistics office reported precisely 7 percent growth for the first half.

The mean survey forecast puts a 70 percent probability on Chinese growth falling somewhere between 6 percent and the magic 7 percent figure for the second half of 2015. A quarter of those surveyed believe the real rate will fall to somewhere between 5 and 6 percent. No one believes it will exceed 7 percent. One of our Ditchley participants refused to enter a figure when he filled in the survey, complaining that “Chinese GDP numbers are all nonsense. The most meaningless statistic anyone is ever asked to estimate.”

But no one thinks it doesn’t matter. The slowdown in Chinese growth is reflected in everything from the collapse in commodity prices to the revenue results (and share prices) of foreign suppliers of capital equipment and luxury consumer goods. And whatever the precise trajectory of the real growth rate, everyone agrees it’s going down.

“There are market concerns related to a bubble or correction, but what is clear to me is that there is a slowdown in the long-term secular growth rate,” Hintze says. “I had been expecting GDP growth to slow to below 7 percent and perhaps as low as 5 percent.” But, he adds, “few market participants had anticipated either the extent of the rally in Chinese markets or the rapidity of their decline.”

Hintze is not alone in being surprised by the great Chinese equity bubble. The Shanghai and Shenzhen composites are obviously disconnected from trends in the underlying real economy. As longtime China watcher and Ditchley participant Patrick Chovanec wrote recently in Foreign Policy: “China destroyed its stock market in order to save it. Faced with a crash in share prices from a bubble of its own making, the Chinese government intervened ruthlessly, and recklessly, to turn those prices around. Its heavy-handed approach seemed to work, for the moment, but only by severely damaging far more important goals and ambitions. Prior to the crash, China’s stock market had enjoyed a blissful disconnect from reality.”

For the past four years, our semiannual survey has asked respondents to assign the odds of security events taking place, such as an armed clash in the East Sea between China and Japan or in the South China Sea between China and its neighbors in the Association of Southeast Asian Nations: Malaysia, the Philippines and Vietnam. A year ago the majority view was that China would experience 7 percent-plus growth throughout 2014, even as respondents assigned 1-in-5 odds to a major clash in the East Sea or South China Sea (which I thought was evidence of a reality disconnect).

Almost all of the commodities that power the Chinese economy are imported through those contested seas, as are most Chinese exports. I recently tested the market effects of dispute incidents in both the East and South China Seas (15 events between 2004 and 2013 for Japan/China and 27 events between 1995 and 2014 for ASEAN/China) using the Kensho financial system. The Kensho studies revealed a consistent price hit in the day following an East Sea dispute of, on average, –0.7 percent for iron ore, with smaller but still consistently negative effects on crude oil, copper and palm oil. Commodities markets also reacted badly to South China Sea incidents, at –0.17 percent, –0.42 percent and –0.68 percent for copper, palm oil and Brent oil, respectively. That logical inconsistency (at least in my view) between sunny growth prospects and security risk is narrowing, however, with the odds of such a clash falling from 10 percent in the January survey to 8 percent in June.

James Shinn is a lecturer at Princeton University’s School of Engineering and Applied Science (, chairman of Teneo Intelligence and CEO of Predata. After careers on Wall Street and in Silicon Valley, he served as national intelligence officer for East Asia at the Central Intelligence Agency and as assistant secretary of defense for Asia at the Pentagon. He serves on the advisory boards of CQS, a London-based hedge fund, and Kensho, a Cambridge-based financial analytics firm.