Geopolitical Risk – Hedging The Unhedgeable?

Authored by Peter Tchir via Academy Securities,

This is the first time (in a long time) that I contemplated not doing a weekend T-Report. What’s the point when by the time you read it, everything in the geopolitical realm may have changed? But, with so much going on and so much chatter about geopolitical (and other risks), it still seemed worth it to grind a report out.

Hopefully you saw our recent SITREPs addressing Iran’s launch of drones and missiles against Israel and the seizure of an Israeli-linked container ship near the Strait of Hormuz. We also sent an informal macro view, urging people to hedge ahead of the weekend (primarily direct distribution and via Bloomberg).

Those piggybacked well on our Geopolitical and Macro Webinar from Tuesday. The discussion started in the Middle East, but covered far more than that, directed largely by a high number of audience questions.

We are engaged in more and more intense conversations about how to manage the geopolitical risk. We have been thinking more and more in terms of Tactical vs Strategic.

We will get back to that in just a moment, but it is important and useful to revisit what happened in markets this week, especially relative to our views.

Intense Price Action

Last weekend we produced a chart that looked More Like A Rorschach Test than a Market Chart. It highlighted two points, both very relevant:

1. There has been almost no consistent pattern between rates and stocks. Who would have thought that the 10-year could go from 4.07% on March 7th, to 4.6% on April 11th and the Nasdaq 100, of all indices, would go from 18,298 to 18,308 over that same period? Certainly not me, as we got the rate call correct, but haven’t seen the drop in stocks that we’ve been looking for (at least not yet). The temptation to end the bearish outlook for stocks on Wednesday night was very high as the Nasdaq rallied strongly from a post-CPI sell-off. I expected it to gather momentum rather than reverse. The only thing staying my hand was the fact that the S&P 500 did not get that same reversal (and some stubbornness). We had hit the high-end of my range on Treasury yields and stocks hadn’t budged. That was (and is) a concern as I’m no longer the bond bear that I was a week or so ago. Thursday brought even more doubt to clinging to the bearish call on equities, as they churned (seemingly unstoppably) higher. Then lo and behold, geopolitical risk raised its ugly head again, which brings us to the next point.

2. Geopolitical risk is not being priced in and when it hits, it hits hard. The prior week, we had a 3% intraday down move in stocks from high to low as geopolitical risk hit the headlines. While not quite as dramatic, a benign overnight session turned into a 2% pullback from the overnight highs to the lows of the day, as the market was hit with a barrage of geopolitical headlines. AXIOS posted a “scoop” that Iran warned the U.S. to stay out of the fight with Israel. Certainly a step worth taking if you intend to follow up with your threat to retaliate against Israel (please see our SITREP webpage). There was more going on in markets than just that geopolitical move, but it is curious how little seems to be priced in. So little that headlines, not so dissimilar from the prior week, could once again roil markets. The market seems to expect countries to name the place, the date, and the time of strikes, and breathes a sigh of relief when those attacks don’t occur as quickly as expected. I’m not a military expert, but I’d hazard a guess that telling the enemy when and where you are going to strike is hardly ever successful. Better to get them on high alert, wait until they are tired, frazzled, and potentially prone to mistakes, then launch an attack. Which is why the Academy team has not breathed sighs of relief and continues to warn about the risk of escalation and expansion.

Two Noticeable Differences

This Week I managed to save my negative view on equities on Friday (though I’ve received pushback that it wasn’t due to geopolitical risk), and there are two things worth pointing out that confirm my nervousness about the market:

• VIX closed at its highest level since October of last year (when the stock rally began in earnest) and briefly traded above 19, bringing it close to “peaks” seen in May of last year. Using options to hedge geopolitical risk makes sense, as we will discuss next. In any case, there seems to finally be some real fear.

• Credit markets gave a hoot. Credit has been one of the most boring markets to cover this year (which is why we haven’t focused on it much – steady as she goes is good for investors, but not particularly interesting for macro strategists). That started to change this week.

  • High yield bonds dropped about 2% this week. While most of the move can be linked to Treasuries, that is a tighter than expected correlation with yields for the high yield market. It trades on price, not spread, and I think spread may be “intellectually” the correct way to think about high yield, but it is not the best metric on a “practical” basis. If anything, I’d tie high yield’s weak performance to the dismal performance of the Russell 2000, which was down 3% on the week.

  • IG credit fared better but showed some signs of pressure on spreads. CDX IG tracked the S&P 500 better than anything (it tends to be correlated to stocks, even more than actual bond spreads, by the nature of who trades it and how), but it widened on Wednesday. Then on Thursday, it barely moved tighter. As stocks were “ripping” higher, CDX barely budged. On Friday it moved higher to almost 55 bps. While still tight, this index seemed to struggle, which is the first time I can say that in months. Having been very bullish on credit, even at the start of the year, when we were looking for it to break out of “ranges” into ever tighter ranges, we turned negative a few weeks ago (mostly in sympathy with equities). This is the first time I’m increasing my bearishness on credit spreads, and not just because I’m bearish risky assets, but because credit now appears to have been caught offsides and has the potential to widen a meaningful amount from here (10 to 15 bps). It will come from hedging. The spread widening did not show up in bond indices, but bond indices are always the last to know what is going on in the bond market . When I look at runs, and the “tone” of the market, I suspect that bonds were marked on Friday at rather optimistic levels and those will be tested by TRACE prints on Monday at the open if the street tries to keep to those levels. This spread widening is happening with higher bond yields, making the move (albeit small so far) extremely important to watch.

With that, I believe that the geopolitical headlines were the catalyst for Friday’s drop, but there is more going on below the surface, none of which is encouraging.

Tactical vs Strategic and What to do About It

Strategic is for longer-term plays. China is not investible as an example. We’ve been largely negative on U.S./China relations for years and on their markets for some time (when the markets chose to get excited about re-opening and we primarily focused on the stress and pressure around National Security). It doesn’t mean that we can’t recommend trading it (I currently like long FXI vs short QQQ for example), but we’ve had a consistent view. That has been helpful to corporations who have been able to adapt their policies ahead of others and were better prepared as they got ahead of what has become a wave of companies looking to expand anywhere but China. For investors, while this call has been good, it wasn’t without bumps, as Chinese stocks had some fierce rallies during this period, and that is the difficulty (we are told) some investors face when trying to incorporate geopolitical risk into their positioning.

On the tactical front, asset managers may be able to take more advantage of geopolitical situations than corporations (though they too can use it for hedging purposes or determining timing of bond issues, etc.).

Even on the tactical front, there are issues around how to implement strategies. In less than 2 weeks, we’ve had 2 drawdowns that can be linked to the geopolitical risk that we have been warning clients about. Having said that, stocks are only down marginally in the past 7 or 8 days and experienced some gut-wrenching rallies if you were caught bearish (as I was). Certainly, this makes options an interesting way to hedge the geopolitical risk, which is likely what we saw on Friday as VIX finally showed signs of life.

A Gameplan for Managing Geopolitical Risk

Now that we’ve set the tone for a market where some cracks have started to appear, let’s go through some ways to take advantage of our views.

First, I am leaning towards the view that escalation and expansion is my base case. That is at the hawkish end of what the GIG said in the most recent SITREPS. The reason, I guess, that I’m at that end of the spectrum is I am not sure that Iran believes all of the rhetoric that has been coming from the U.S. about what we could or would or might do if Iran attacks Israel. Israel was attacked by Hamas and look at the current posture of the U.S. If I was an Iranian leader, I might think I could craft a plan where Iran could attack more directly than it has been (cutting through all the proxy “noise”) and not face severe reprisals from the U.S. Yes, Iran would need to be prepared for a strong response from Israel which is fighting for their existence, but that might be a chance I take, given what has gone on since the October 7th attack on Israel by Hamas.

So, I’m bearish and want to hedge (though I’m bearish for other reasons other than just the geopolitical risk, so that will affect how I think about the market, compared to those who are bullish and are just worried about the off chance of geopolitical risk).

What to hedge depends on your scenario for how any escalation and expansion develops. Here is my quick take:

• Higher energy prices. Regardless of any potential economic slowdown from escalation and expansion I see energy prices spiking higher. Brent to at least $100 (from there, the Saudis potentially increase their production to generate nice profits and ease the pain for their customers). It should hit energy across the board as not only will Iranian production be cut, but shipments (so far not really affected) also will become affected and if some refining capacity is taken offline or is unable to ship, it would further amplify energy prices.

• Bad for Western economies, less bad for China. We have already been decoupling. I’m clearly in the camp that we are competing with China rather than dependent on China (The Threat of Made by China 2025).

  • Higher energy prices will hit all economies, but we’ve seen, I believe, since the start of the war in Ukraine, that adversaries who are willing to “bend the rules” have been more successful at quickly adapting to changing geopolitical environments. All evidence points to Russia being back to close to full exports long before Germany gets back to full imports. I see no reason why it won’t be different this time and the West will face more energy inflation than China.

  • Shipping problems will be felt more acutely by the West than other countries. Not only have the Houthis been “selective” in which ships they attack, but China has also invested significant amounts of money into ports across the globe and that money should buy them preferential treatment (very smart moves by China to expand their influence globally, with a real practical potential benefit).

With that outlook on the potential consequences of escalation and expansion, we can examine hedging.

Options are interesting but pose a very different problem than when we use options to hedge against economic data or the Fed or other “known” events. If you worry about jobs being too strong or too hot, you can buy options that expire as close to NFP being released as possible, minimizing the cost. You may also be comfortable waiting to buy those options until we are closer to the time of the event. Why buy options for jobs data, for example, 3 weeks before the data, when you can buy something shortly before ADP comes out? Weekly options or even daily options are legitimate choices when hedging risks related to a specific event. That just isn’t viable with geopolitical risk. Unless the enemy decides to tell us the time and place (which is foolish for them to do), then we need to buy options today. But what maturity do we need? Weekly and daily options are cheaper than longer-dated options, but if you constantly have to roll those option positions, you generally would have been better off buying longer-dated options up front. Is that what happened on Friday? Investors, many of whom were far more worried about missing downside than upside, had been “cute” with their hedging strategies? Trying to “time” geopolitical events? The odds of having had protection in place on the two days you needed it in the past two weeks due to geopolitical headlines were probably not great. Remember, 0DTE and weekly options are too short dated to go into the VIX calculation. I’m going to view Friday as the first day people got serious about their hedging (at this point you might also be hedging the surprise that yields have risen, the Fed is being priced out of the market, and stocks didn’t care much or at all).

Buying VIX calls could be an interesting hedge. Various option selling strategies have become popular. From covered call writing to selling puts “where I’d want to own the stock” have become prevalent. There are ETF flows indicating the popularity of strategies that tend to suppress vol. Daily and weekly options have been favorites for some of these strategies, as over time, even more income is generated by doing it every day, than engaging in longer-dated options. If that vol suppression was to reverse, we could see a sharp spike in VIX. It might already be too late to jump into this market, but it is an interesting way of playing it. As a corollary, options on CDX widening could be interesting as the indices are correlated to stocks and credit spreads usually have a decent degree of correlation to equity vol, so that might be an interesting and potentially cheap way to try to take advantage of a larger move. I do think that the valuation problems are more isolated to equities than credit, but current positioning may be one-sided enough that you get good bang for your buck.

Long energy products and stocks. I wouldn’t bother with options here as I think there are so many reasons to like energy (still largely hated by hedge funds (contrarian), a more robust effort to ensure we have traditional energy as we build out sustainable energy, the rise of India, etc.). The commodities are particularly volatile, so I prefer energy companies, but both work. Given the volatility, you have to be careful on how overweight you are, but that is my favorite hedge.

Rates. This is tricky. First and foremost, we were looking for 10s to get into a 4.4% to 4.6% range, and we hit the top of the range. That alone makes it difficult to be bearish yields here (though suddenly, it seems more bearish views are emerging from the woodwork). We certainly had some “flight to quality” trades on Friday as the 10-year yield fell as low as 4.48% several times during the day. But that rally faded a bit into the close, to finish at 4.52%. I understand the “flight to safety” trade but think it will be short-lived.

• Higher energy prices will stoke inflation fears.

• As we’ve been in the process of decoupling, the potential economic slowdown won’t be immediate, making it difficult for yields to go much lower. In fact, there is an argument that it would hasten re-shoring and increase domestic jobs.

• Military spending. Whatever the economic slowdown is, we should see spending on military increase globally in the event of escalation. It was bad enough seeing Russia invade Ukraine, but yet another larger conflict breaking out will (and should) make countries across the globe rethink current levels of military spending in a world where the military option is no longer off the table.

For those reasons, maybe you can buy some short-term calls on Treasuries, looking for what I think will be at most a “knee jerk” reaction that will fade quickly. Could we break 4.4% to the downside on yields if we get escalation? Sure, and I wouldn’t fight it too hard here at these levels, but I would be looking to fade the rally rather than piling on because “this time is different” and flight to safety doesn’t seem overly compelling to me (given my views above).

Bottom Line

It is difficult to get markets right, even if you knew the economic data ahead of time (who had hot CPI, with much higher bond yields, and the growth stocks outperforming?).

That is even more difficult on the geopolitical front where there is no set timetable, there may or may not be “discrete” events that we can manage risk around, and there are competing factors. On the one side, apparently peace talks continue to “progress” (though I suspect that is for show) and we’ve gone through an entire report without once highlighting that Israel is a nuclear power (should be a deterrent) or that Iran is on its way (which might give Israel the impetus to act, especially if they feel more and more isolated).

A lot going on, and Thursdays’ strength in equities makes me nervous but:

• Neutral on rates, looking for an opportunity to short again.

• Bearish on equities (think the VIX and CDX moves help that cause) but still need to respect the upside. I prefer bearish views with some calls rather than the other way around. • Definitely looking for a pullback in credit and suspect that there might be some good relative value ways to use credit markets to hedge out risk that haven’t been as picked over as things like VIX calls.

• Like energy – though prefer the stocks to the commodities, but like both.

Good luck, hopefully this note is overkill, and we wake up Monday morning to a world that is a better and safer place, but it cannot hurt to be prepared.