Citi: Volatility Too Low Given Risk of US-China Spat

Bloomberg

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00:00It's a great time to be a global macro strategist as well with so much going on and I want to dig

00:05into a lot of the major themes in this conversation. But I do want to start with trade because we've

00:09had the latest tit for tat now cooking oil versus soybeans. I mean, is this an escalation? Do we

00:15sit here tomorrow talking about the taco trade again? Or could this potentially get worse?

00:20Well, I think the key point here is I've been making the case for a couple of months that

00:25there's a lot of complacency around tariffs and it's really two dimensional. One is that

00:30people think there's been no economic impact and therefore there won't be any economic impact.

00:36It takes time. And so I think we'll see a lot more impact on inflation and growth going forward.

00:41But the other issue is that there's been slow but steady escalation for the past couple of months.

00:49Trump has been putting his Section 232 sector tariffs in play behind the scenes. China and

00:56the U.S. have been doing some tit for tat. So I know all the excitement in the market was around

01:02I'm going to do 100 percent on China. But if anyone was really paying attention, which no one really

01:07wanted to, the escalation was picking up for the past few months. Well, we have been here before,

01:12though, haven't we? Because in 2016, in the first Trump administration, we saw similar sorts of trade

01:17tariffs. Are there any valuable lessons from history or is this time different?

01:22I think this time is completely different. I mean, even if you look at the size of the tariffs,

01:27I mean, back then, the effect of tariff rate barely moved. This time around, the effect of tariff

01:32rate has gone from 2 percent to 18 percent. So it's much bigger. It's much more organized.

01:38It's clearly meant to last. And I think the market is struggling in terms of how to discount that.

01:45And all I can say now is, again, I think when I look at market pricing, when I look at volatility

01:50levels, it's far too low relative to the underlying risks that are building around

01:55the tariff issue. One of our guests yesterday characterized the tariff issue and in particular

02:00rare earths as a rare earths cold war. Would you share that view and how damaging could this be to

02:07level? Well, you know, I think that's right. I mean, if you look at Trump's long-term ideology,

02:13the real plan was strategic disengagement from China. And the kink in the road was clearly that

02:22China has been spending the last couple of decades basically monopolizing the refining of

02:27rare earths. So that, you know, that has been the sticking point that if it were up to Trump,

02:32the escalation would be much, much bigger. The tariffs would be much, much bigger.

02:37But what he's learned is it's quite difficult to do that when China has a monopoly on 90 percent of

02:43all the rare earths we're finding in the world. Well, of course, trade's just one macro risk. I

02:48mean, we've forgotten that there is still a major war raging in Europe between Russia and the Ukraine.

02:52There is still a shutdown in the US. The Japanese and French governments are in turmoil.

02:58We had a Bank of America surveyed today warning of AI bubble risk. So do you have a sense that the

03:03bad news is kind of starting to pile up? And can this rally continue in the face of it?

03:08Yeah, I'm a little bit wary of the rally. And again, the way I think about it is I do look at

03:14implied volatility levels. And by two weeks ago, we were sitting across every financial market at the

03:20lowest implied ball in months, if not years, in some markets. And given the risks around everything,

03:27there's a mismatch. So I do think that the fourth quarter is going to be very different in flavor,

03:34much more volatility. I'd be wary of chasing these equity market credit market rallies because there

03:40are a lot of macro risks out there. Well, there is a sort of broad general assumption that the only

03:46thing that really undermines a bull market is a recession. Do you think that's true? And if

03:51there isn't a recession on the horizon, is there any reason to think that this bull market couldn't

03:55keep going? No, I mean, listen, I think it's absolutely true that ultimately the thing that

04:01will kill off this rally is a recession. And frankly, I don't see a lot of recession risks out

04:06there. I mean, I think even the US economy, there's worries about jobs growth. But if you look at

04:11activity elsewhere, it looks OK. It's soggy, but it doesn't look recessionary. But I guess

04:17the question for investors would be, are you prepared for another 10% to 15% correction?

04:24And if you are, fine. You either hold on to it or you buy the dip. But 10% to 15% corrections are

04:29pretty painful. And that, I think, is the risk we're looking at as opposed to a genuine recession risk.

04:35One of the things helping support this rally is, of course, the easing that we've seen from the Fed

04:39so far. We're anticipating more to come. And remarks from Jay Powell today suggesting that

04:43the jobs market is assuming a greater influence on future policy decisions. Do you agree with that?

04:49And do you feel inflation is now under control in the US? You know, listen, my view on the US and the

04:56Fed is that the Fed is turning increasingly dovish. Part of that is being driven, I think, by pressure from

05:03the Trump administration. So the focus on the jobs market isn't unreasonable. But we are in a world

05:09where inflation is rising. And to me, the biggest risk out there, about Japan and France, and the

05:16biggest risk is that the Fed overeases into a rising inflation environment. And we see a significant

05:22sell-off in the long end of the US bond curve. That would be the thing that worries me most.

05:26What about debt and deficit in the United States in an environment of an ongoing US shutdown and no

05:33real fiscal motivation to do anything about this problem? And I think partly this is being reflected

05:38in the gold price. Does this worry you, the amount of debt?

05:41Yeah, I mean, I'm usually a wall of worry. And I've worried about fiscal policy and advanced economies

05:46for the past three years. And when I speak to investors these days, there seems to be a lot

05:52less worry about US fiscal policy. I'm not sure why that's the case. And the only thing I'd say

05:58about the shutdown is that before the shutdown, there's a really interesting fiscal issue, which

06:03is, this is all about healthcare spending. The Democrats are trying to stand up for healthcare

06:08spending. The Republicans are trying to cut healthcare spending. And if the Republicans have

06:12to compromise, I think that's going to be a moment where people realize that the US fiscal

06:18problem is still a clear and present danger.

06:20You said a moment ago, forget about Japan. I can't. I'm sorry. I've got to ask you about it

06:24because we could have a situation where the government changes without an election. How closely

06:29are you watching the situation unfold? What are the permutations for you?

06:32Yeah, I spend a lot of time looking at Japan. So I need to be clear that you need to keep watching it.

06:38I guess, you know, listen, there is so many potential paths for market volatility from Japan.

06:46One potential path is we don't know what this government's going to look like. The uncertainty

06:51around Japanese politics is higher than it's been in years. And, you know, the worry the market has,

06:57which I think is a reasonable worry, is that whatever combination we get is going to spend

07:03a lot more fiscally. You're seeing a big sell-off in the long end of the JGB curve. The other thing

07:09I worry about is that the market assumes that the politics are taking BOJ rate hikes off the table.

07:15I think that's wrong. So we can easily find ourselves in a situation next few months where

07:19the market's priced out BOJ rate hikes, the BOJ does hype rates, the currency rallies, and we see a

07:26repeat of the volatility that we saw last summer.

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