Political Chaos: Wall Street’s New Volatility?

Volatility on Wall Street might be low, but Main Streets around the world are more restive than they have been in years. And that could mean tumult ahead for financial markets and economies.

“Judging by the mood in global markets, the financial crisis is over,” a team led by Citigroup chief global political analyst Tina Fordham wrote in a research paper. “Yet it seems like political risk features in the news every day: another street protest; a new government collapse; a rally calling for independence; the outbreak of civil conflict.”

Indeed, the S&P 500, a broad gauge of U.S. equity performance, is trading at its highest levels on record – more than recovering from its financial-crisis lows hit in March 2009. At the same time, the CBOE’s VIX, a measure of implied volatility on Wall Street, is trading at its lowest levels in more than a year.

It’s not just American blue-chip equities experiencing a jolt of investor optimism – Markit’s gauge of the cost to insure high-yielding corporate debt stands at its tightest spread since November 2007, while spreads across a swath of European firms are narrower than they have been in four-and-a-half years.

Financial Stability Hides Political Strife

Citigroup warns, however, the apparent stability across financial markets masks smoldering political instability around the world. In fact, the average yearly tally of elections, government collapses and mass protests has surged a staggering 54% to 21.7 in the years following the financial crisis, compared to the decade prior, according to the bank’s research.

And the types of “risk events” vary greatly and are truly global in scale. Among the major events in recent years have been the Arab Spring uprisings that have thrown a slew of nations in the Middle East and North Africa into chaos, the dramatic fall of Ukraine’s authoritarian government, and a coup d'état in Thailand.

Even in some of the world’s strongest unions, where blood isn’t necessarily shed, the results of civil unrest can be eye-popping. Take, for example, euro-skeptic parties seizing control of 30% of the European Parliament in elections late last month in response to sky-high unemployment and painful austerity across the European Union. Or the first American government shutdown in 17 years, caused by seemingly irreconcilable differences between the Democratic and Republican parties.

Citi said the Occupy Wall Street movement in which predominantly young Americans protested against what they perceived as the ills of capitalism and inequality created by the system, “crystallized the sentiment of ‘We are the 99%,’ pitting elites against the overwhelming majority.”

That’s the heart of the issue: inequality. Be it in political power or wealth, cries that a small fraction of the world’s population controls a seemingly ever-increasing swath of the world’s power have ricocheted across the globe – sometimes with dangerous consequences.

“Parents fearing their children will be worse off than they are is not fear of inequality per se. Rather, we think it should be interpreted as anxiety that the system is changing in a way that people have less faith that the path to prosperity, and the opportunities it affords, will be as open to their children as it was to themselves,” Citi noted as it grappled exactly what the definition of “inequality” is in the modern context.

Ironically, well-intentioned policymakers at major central banks, including the Federal Reserve and European Central Bank, probably exacerbated the problem in their quest to pull the global economy back from the brink and jumpstart growth.

“Cheap money has boosted asset prices. This will have helped to stabilize fragile economies,” Citi said in the research note. “However, it also widens wealth gaps; the asset-rich have got richer. But high levels of unemployment suggest that the trickle-down to a broader constituency has been slow.”

Geopolitical Tumult Could Morph Into Economic Hindrance

Strife across developed and emerging markets could have profound consequences going forward, according to Citi.

Thus far geopolitical volatility has been broadly localized, meaning events have largely impacted economies and markets directly surrounding the source of the trouble. The overthrow of Ukraine’s government and Russia’s subsequent annexation of the Crimea offers an example of that trend. Russian and Ukrainian markets have taken hits, but U.S. equities still trade at record highs. The recent coup in Thailand had similar consequences – the impacts were mostly constrained to Thailand and other Asian asset markets. The same situation presented itself during conflicts with Syria and Libya and turmoil in Egypt – just to name a few incidents.

A notable, although not particularly long-lived, exception was the eurozone debt crisis. Worries that a default in a periphery nation such as Greece or Cyprus could tear apart what was then a 17-member currency bloc sent global equities plummeting some 25% in the summer of 2011. A round of bailouts funded by core countries, particularly Germany, helped snuff out those sparks. Finally, a vow by ECB President Mario Draghi in July 2012 to do “whatever it takes” to hold the group together numbed markets to any woes since then. Citi even said clients have essentially stopped asking about the state of governments in the euro despite ongoing concerns there.

Callousness toward emerging flashpoints could catch Wall Street by surprise, Citi warned.

“Since the fall of the Berlin Wall 25 years ago, companies and investors have operated in an environment characterized by relative stability, the erosion of ideology as a driving force, rising integration in the global financial system and unprecedented economic expansion,” Citi said, warning that if the shift toward instability gets worse, “it could fuel a change … prompting more frequent disruptions to trade and commercial relations and challenges to the global system.”

More specifically, Citi said political unease “fuels uncertainty” and leads households to increase savings and businesses to lower capital formation, “reducing two major components of domestic aggregate demand.”

Meanwhile, leaders who will likely hold less political capital as a result of a restive populous could be forced to make decisions that seem smart in the short-run, but could be painful in the long-run. That includes shying away from reforms, hiking taxes, and tightening regulations for “punitive rather than … sound economic reasons.” Citi added that all the factors “can result in negative incentives to work, save and invest: ultimately suppressing future growth.”

“For now, global markets seem more interested in Janet Yellen’s next move on QE than Vladimir Putin’s next move in Ukraine. Maybe this will change, but only when we have seen the end of [developed market] near-zero policy rates and open-ended liquidity at those extraordinarily low rates,” Citi said.