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LONDON (Reuters) - The turmoil in Washington surrounding Donald Trump's presidency is rattling world markets, and the burst of volatility could force investors into a strategic or tactical rethink of how much risk they are happy to face.
Increasingly damaging revelations about the Trump administration's and election team's dealings with Russia triggered the biggest fall on Wall Street on Wednesday since last September and a stock market slump around the world.
After months of major stock markets posting record highs and historically low volatility across a range of asset classes, a reversal was always on the cards.
Now that it has come, the question is whether it ends up being a one-off or marks the start of a prolonged reversal which sees investors cut back on risk and adopt more defensive positions.
A broad U-turn would likely require one or a mix of the following scenarios: impeachment proceedings against Trump get underway, his growth-boosting legislative reform agenda is delayed, the U.S. economy begins to contract.
None of them are mutually exclusive, and it remains to be seen if events play out that way to any degree. But the "Trump trade" that lifted stocks, the dollar and bond yields appears to have evaporated.
The dollar, two- to 10-year Treasury yield curve and yields on 10-year Treasury Inflation-Protected Securities (TIPS) are all back where they were before Trump was elected in November. After months of relative plain sailing, investors are now bracing for stormier weather.
"We have to be cognizant of volatility. It's a question of keeping risk levels appropriate, and that's something we were doing anyway. Our portfolios were well-positioned," said James Athey, portfolio manager at Aberdeen Asset Management in London.
"Do we dial back further? That's the conversation we'll be having over the next day or two," he said, noting that he had cut back on "short" positions in safe-haven fixed income assets and the Japanese yen in recent weeks.
Aberdeen has $480 billion of assets under management.
The VIX index .VIX of implied volatility on the S&P 500 .SPX was jolted from its slumber on Wednesday and chalked up its seventh-biggest rise in percentage terms since its launch in 1990.
This followed news that Trump had asked then-FBI Director James Comey to close an investigation into ties between former White House national security adviser Michael Flynn and Russia.
Joost van Leenders, strategist and portfolio manager, multi asset solutions at BNP Paribas Investment Partners, which oversees 580 billion euros of assets, said he and his colleagues are discussing U.S. political risk on a daily basis.
"We were cautiously positioned to start with, so for now we don't have to change our position, but I do not rule out future changes," he said.
Some, like Tom Wu, chief investment officer, Global Investments, Yuanta Securities Investment Trust, Taiwan's second-largest fund manager, aren't holding back.
"An impeachment might happen, or it might not. Any uncertainty, including this uncertainty, is something that investors don't care for. So we'll be unloading all of our holdings in U.S. stocks this month," he said.
Few investors will follow that example, but many reckon U.S. markets are expensive. The U.S. economy is already into its third-longest expansion ever, and a recent fall in the U.S. economic surprises index suggests it is running out of steam.
The gap between the U.S. and European surprises indexes is the widest in two years, U.S. corporate earnings growth is double-digit but still lagging the euro zone, and the political turmoil that was supposed to beset Europe this year is concentrated in the United States.
"There is no recession in the pipeline, but the U.S. economy could slow next year," said Didier Borowski, head of macroeconomic research at Amundi, Europe's largest asset manager with 1.27 trillion euros of assets.
"So part of the correction is welcome because from a valuation standpoint, the U.S. equity market was in bubble territory," he said.
As stocks slide, safe-haven assets like bonds that had been shunned in the months following Trump's election win in November are back in demand.
The spread between two- and 10-year Treasury yields US10US2=TWEB is its smallest since before the presidential election. This so-called yield curve flattening suggests investors are losing faith in the economy's ability to withstand higher interest rates.
Money markets have slashed the probability of the Federal Reserve raising rates next month to less than 60 percent from over 90 percent last week.
John Taylor, portfolio manager at Alliance Bernstein, which has $498 billion of assets under management, said the political, economic and market volatility is keeping them on the defensive.
"Our cash position is quite large – 10 percent vs below 5 percent historically ... and we will stick to assets with strong fundamentals, such as bank bonds and local currency emerging market debt," Taylor said.
Reporting by Jamie McGeever; Additional reporting by Abhinav Ramnarayan in London and Faith Hung in Taiwan; Editing by Hugh Lawson