Financial Markets As War By Other Means

Authored by Steven Englander, Rafiki Capital Management,

Over the past few years, political events have begun to consistently dominate economic data in their impact on asset markets. Today is just another example.

This has important implications for the nature and timing of the shocks that hit asset markets, as well as the risks that investors face. Below we argue that severe information asymmetries surrounding such political shocks and the related incentives for profit from those moves creates at least three core concerns:

1.     Asset markets become the barometer of successful policy, a job they simply aren’t suited for.

2.     Policy makers have an incentive to try and move the market to validate their policies.

3.     State actors have the incentive to time investments such that they make money on political events.

4.     Less likely, but still possible, some political events could be driven in part  by a profit motive.

Asset markets become the barometer of successful policy, a job they simply aren’t suited for

A byproduct of the increased significance of political shocks is that asset market responses are now increasingly the barometer of policy success or failure. Such use of asset markets goes far beyond their reliability in such matters.

Consider the recent concern surrounding U.S. tariffs on Chinese goods. The trade spat is largely being played out in financial markets, with the reaction in equities being used to determine the wisdom of China or the U.S.’s policy.

​The US tariffs seem to have been chosen to make a point on economics and trade. China’s response today was driven by the desire to inflict as much visible political and financial market pain. It is hard to believe that a country with higher tariffs and US exports that are both labor intensive and almost four times its US imports can win a trade war. However, this could emerge if US policy is more sensitive to asset prices and politically sensitive products than China’s policy is to the goods that are newly tariffed.

At today's cash open... doom and gloom.

Even before today, one factor behind the S&P 500 Index’s sharp fall drop  was China’s ambassador to the U.S., Cui Tianka’s, recent indication that China wouldn't rule out the possibility of scaling back its purchases of Treasuries in response to tariffs imposed by the White House. This was widely interpreted as a weakening of the Trump administration case for tariffs.

A perceived vote of confidence from financial markets can have real world consequences in strengthening respective negotiating hands: positive reactions give policy makers more leeway to push their policies; a market sell-off will increase pressure to back off or find a quick resolution.

At today's cash close - euphoria.

Similarly, if markets responded negatively to a territorial dispute or some military intervention, the perception would be that the policies or actions were being rejected. When markets are already fragile because of other factors it would not take much intervention to turn a pullback into a rout.

Once it becomes clear that financial markets are the arbiter of decision making, and can strengthen hands in disputes, policy makers have an incentive to try and move the market to validate their policies.

Not every policy dispute can be affected by asset market manipulation and not every asset market can be manipulated readily, but it seems likely that as the incentives increase, they will more often coincide with opportunity – and combination of the two tends to be a good predictor of what is likely. Nor am I the first one to think that a sovereign might manipulate financial markets for political reasons.

Such manipulation would be illegal if you or I did it, but manipulation by well-funded sovereigns, reserve managers and sovereign wealth funds would be hard to detect and even harder to sanction.  Mild forms of such behavior already happen from the private sector side. Foreign-exchange reserve manager "vigilantes" often use veiled threats about trimming their exposure to the dollar to encourage the U.S. not to be so reckless when it comes to spending and debt issuance. Those warnings can affect the price of Treasuries, and raise borrowing costs in the US.

Most disturbingly, in some scenarios state actors have the incentive and capability to profit on political events, or to choose political events that will allow them to profit.

If sovereign nations can affect asset prices for political gain, they can also profit financially from the moves. Were China or another country in a trade dispute with the U.S. to contemplate retaliatory tariffs, they’d be strongly tempted to buy puts on equities in advance of the announcement (or calls if the retaliation is surprisingly mild.) A middle eastern country whose acts will affect oil prices has an incentive to pre-position in oil futures. Any country taking a ‘cold war’ to a ‘hot war’ would have a temptation do the same. It is unlikely that most countries would generate an event simply to profit from the subsequent asset price moves, but if the event is going to occur anyway, why not take advantage of the opportunity to generate a side profit?

Could this be done?

A respectable sovereign with a sovereign wealth fund and sizable reserves would find entering large positions relatively easy. Connections with their governments are tight, management is often centralized, and counterparties are accustomed to their dealing in large size. Interventions in exchange markets are criticized but no one shuts down an embassy because of it.

Rogue countries with the means to generate market moving events (e.g. North Korea) by nature have the motive (poverty and sanctions) and means (expertise in exploiting weakness at the edges of the global financial system) necessary to engage in such behavior. Poor does not mean unsophisticated in financial markets. . Further, it has tight control over timing and scale of and event such as a nuclear test – and the market response is fairly predictable. They would need to corrupt market participants somewhere, but that’s unlikely to have ever been an insurmountable barrier, and the availability of anonymous cryptocurrencies likely lowered that barrier further.

Sanctions, know-your-customer rules, and anti-money laundering edicts make it challenging for rogue governments to enter positions big enough to generate sizable profits. The effort to enter large positions through fringe operators would trigger red flags. A big levered position put on with precision timing will generate some attention even without an ‘event’ and should certainly attract attention if it generated outsized profits.

My guess is that profit-seeking from events occurs in small size already, but sanctioned and rogue countries will have difficulty in putting these positions on in size. They may nevertheless try.

None of this is to suggest that the large-scale manipulation of asset markets is likely to become a consistent concern anytime soon. The winners and losers of these behaviors are relatively clear: winners involve state actors with less interest in market confidence and transparency, whereas losers include private sector investors who would rarely have any information advantage, as well as the broader economic and financial community with reduced confidence in the fairness of asset markets. Volatility would not necessarily increase, although that’s likely as well, given that a sudden market shock is likely to make a sharper political point.

We have already seen the integrity of institutions such as elections and social media called into question. Public asset markets are resilient, but they’re vulnerable just the same.

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1/ Equity prices are meant to measure the discounted value of a stream of cash flows. This can be correlated with whether policy is good or bad but the correlation can be positive or negative and the presumption that there is a tight link is hard to justify. For instance, a tax measure that simply transferred tax revenues to corporates (and didn't generate an investment response) is almost certainly a negative for social welfare but likely raise share prices in the short term.

2/ We use terms like ‘manipulation’ as descriptors, without taking a position on their inherent ethics. If you (as a country) are facing an unfriendly action from abroad, why not use all the means you have available to respond? The view that asset markets as especially sacrosanct, even in the face of unfair provocation is not obvious.