Geopolitical vega

Hedging the unhedgeable

A quick look out the figurative window seems to confirm my weather forecast for 2024: (1) the Fed risks its credibility, yet again, by underestimating US potential growth, inflation, neutral interest rates, and the need for higher-for-longer interest rates; but (2) the biggest threat to the global economy this year comes instead from intensifying geopolitical disorder, or what I’ve termed Global entropy.

My concerns on the risks to Fed credibility were not assuaged by last Friday’s payroll report nor the FOMC’s choice to not cut rates last week.  The report was still strong overall and an occasional – very occasional in this cycle – disappointment of market expectations is normal.  Similarly, while the de-escalation following Iran and Israel’s unprecedented direct reciprocal missile exchange is welcome, the trend towards disorder over the last several months has been undeniable and consistent with my thesis from Global entropy: Enter the dragons.  Indeed, relative to the 2024 timeline for expanding Global entropy that I proposed in May you live in interesting times, The Wheel of Fortune, the potential for broader global conflict has risen, not fallen, in my estimation.

Yet, it would be difficult to detect signs that markets share my concerns, looking at options prices.  While the Iran-Israel confrontations raised option-implied volatility and correlation off historic lows at the end of March, both remain cheap, offering excellent opportunities to hedge against global calamity at reasonable cost with, in many cases, likely upside in nearly all scenarios other than a return to March’s lows in volatility.  Markets’ failure to price the reality that I see likely reflects two persistent behavioral trends: (1) paralysis among hedgers when faced with unquantifiable risks; and (2) a mistaken view of “geopolitical alpha” by speculators that global tensions can be reliably faded for profit, i.e. “buy the dip.”¹

I explain here why both approaches are mistaken and how one can use derivatives to leverage “geopolitical vega” both for profit and as portfolio insurance.  I detail customized baskets with a targeted cost of 1% of capital that offer an expect value of ~2x-4x premium and provide ~10x-30x payouts in the three main risk scenarios I see: a Fed policy error, expanding global disorder and a direct confrontation between the US and China.  A fuller asset allocation plan for long-only investors is forthcoming.