JPMORGAN: 3 political flash points are set to dictate the future of global markets. Here's how investors should get ready for them.

REUTERS/Bobby Yip

• Investors are about to be confronted with three geopolitical stress tests that they may be underprepared for, according to a team of cross-asset strategists at JPMorgan.
• They laid out the assets that are most vulnerable to each situation, how markets are priced for adverse outcomes, and where to find attractive hedges for the worst-case scenario.
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JPMorgan's cross-asset strategists come away impressed when they survey the state of global markets.

Their conclusion is not because all is rosy out there. Instead, they think markets have shown incredible resilience to the series of blows that have been from all sides.

Within the last week, for example, a liquidity crunch slammed the vital market for overnight repurchase agreements, or repos, in a manner that was last seen during the 2008 financial crisis. This situation has not yet been fully resolved, and the Fed plans to continue pouring cash into this market daily until October 10.

JPMorgan does not view this market's instability as a systemic threat to the financial system. Investors in other markets have also largely overlooked the liquidity crisis. But other looming threats may be harder to ignore.

"Investors should be more suspect about markets' readiness for possible escalations in Q4's three geopolitical flash points of Iran, the trade war, and Brexit," said John Normand, the head of cross-asset fundamental strategy at JPMorgan, in a recent note to clients.

He went beyond only naming these risks by laying out the assets that they make vulnerable, and how investors can hedge adverse outcomes.

1. A prolonged oil spike

An oil spike could deepen the global economy's slump even if it doesn't end up triggering an outright recession.

The risk of an oil shock resurfaced last week when Saudi Arabia suffered the worst attack on oil-producing infrastructure in history.

Normand noted that the US shale boom has made a massive oil spike less likely, relative to historical episodes. The market appears to be pricing in this view: most oil assets across fixed income, credit, commodities, and stocks are not positioned for an extended disruption, Normand said.

He is currently overweight US energy stocks, high-yield energy credit, and the Russian ruble - all assets that are exposed to oil-supply disruptions. He added that even without the threats to supply, he would probably own these assets given their relative cheapness to oil.

Read more: The 'single biggest risk' to investors is being widely ignored - and Morgan Stanley warns it could spawn a recession within months

2. Another US-China tariff hike

It is "easy to envision" an escalation of the trade war despite the belief that President Donald Trump would pursue a detente ahead of the 2020 election, Normand said.

He finds the market's positioning on this issue to be already be defensive, given investors' below-average exposure to emerging-market equities, copper, and the Australian dollar.

The Chinese renminbi seems to be the most expensive asset among those exposed to the trade war, Normand said. This implies that a good hedge would be to underweight this currency rather than EM stocks or the other exposed assets listed above.

3. Hard Brexit after early elections

The next step in the United Kingdom's protracted exit from the European Union is most likely yet another extension, in Normand's view.

After the October 17-18 EU leaders' summit, he expects the UK to request a three-month extension and then stage an early election in November or December.

Meanwhile, JPMorgan's economists sees a conservative majority in parliament as the likely election outcome, which would only intensify fears of a hard Brexit.

The assets most affected by this outcome - including the pound - still look slightly cheap and underowned on average, Normand said.

However, the FTSE's valuation, based on its forward price-to-earnings ratio, is slightly above average. Piled on to that is the fact that inflows to FTSE exchange-traded funds have been above average in 2019. This combo makes the FTSE an attractive underweight relative to US stocks, Normand said.

Get the latest Oil WTI price here.