In this piece we try to answer some of the lingering questions following the events in Iran and explore resulting opportunities. We think that: (a) US foreign policy in 2020 could be what trade war was for 2019; (b) the risk of escalation with Iran will decline in the near term but rise into the US elections; (c) we will live in constant fear of a policy mistake as the proxy and cyber war goes on; (d) the hunt for hedges has just begun, with gold and to a lesser extent bitcoins winning at first glance; (e) we are still operating under the post-trade war reflationary market zeitgeist, so sudden moves lower in US Treasury yields or calls for Fed rate cuts are opportunities for contrarian trades.
Foreign policy is the new trade policy; Iran is the new China. Trump needs to walk the fine line between appearing hawkish in foreign policy for his base without imploding the economy along the way. Our assumption here is that he is gearing up to contest Joe Biden in the 2020 elections, and that he sees foreign policy as Biden’s most exposed flank. The strongest meme in this conversation is probably the quote from former Obama Defense Secretary Robert Gates’s memoir, when he said that Biden “has been wrong on nearly every major foreign policy and national security issue over the past four decades.” (Also see here, and here for more on this.) In short, Trump wants to come into the elections as a firm and decisive steward to US foreign policy, but for this—alas—there must be conflict.
We see two takeaways from Iran’s retaliation: (1) more is coming and (2) the risk of a policy mistake will remain high. On the former, we take Iran’s characterization of yesterday’s missile attacks as “proportionate” to be a face-saving delay tactic. It creates a window for de-escalation, which President Trump eagerly jumped through (tweet: “All is well!”), giving Iran time to develop its response. Iran could, for example, use this time to orchestrate a larger, more significant response that has a maximum impact on the US elections. But in the meantime, the proxy conflict in the region and in cyberspace will continue, and we will have to learn to live with the constant risk of a policy error leading to escalation. In the case of Iran’s attack yesterday, the obvious counterfactual is: what if US troops had been (accidentally) killed in the Iraqi base? While not impossible, it will be very hard for Trump to back down.
The hunt for proxy-Treasury hedges is on. A back-of-the-envelope calculation using rolling z-scores suggest that, in terms of relative magnitudes, the moves in gold and bitcoin showed the largest and most sustained reaction over a 5-day window. We need more evidence, of course, but at first glance they seem to be winning the race for the best hedges for this type of geopolitical risk and, as such, may become a more integral part of asset manager’s portfolios. (Note, we are ignoring the obvious assets such as oil, defence, and cybersecurity stocks that are directly impacted.) The moves in other popular safe-haven assets such as Treasuries, the Japanese yen and the Swiss franc were smaller and/or reversed quicker. In fact, they proved to be an opportunity to express contrarian views, much in the way some investors have used the mini sell-offs during the tensions in North Korea in the past.
The sharp fall in implied rates suggesting a cut by the Fed seems especially exaggerated, in our view. Using the Bloomberg model, a full 25 bp rate cut is now priced in to the curve for 2020, compared to about 15 bp before the Iran event. The move is understandable since geopolitical risks force investors to incorporate greater negative tail risks into their forecasts. That said, we think this move will ultimately prove to be an opportunity. First, we maintain the view that—all else equal—there is no reason for the Fed to cut rates this year. Second, and as aforementioned, we think it is highly unlikely that Trump will let the situation escalate to the point of impacting the US economy in an election year. We are still operating under the same post-trade war reflation trade zeitgeist as we ended 2019. At least until we get closer to the elections.