Only once (China-led sell-off of August 2015) since the Great Financial Crisis (2008-2009) had VIX hit 50. Such sharp repricing in risk has inevitably infected global financial markets, through a flight-to-quality that has primarily hurt equities. A majority of the world’s equity indices are now trading lower than by end 2017; even the S&P500, which was up 7.7% year-to-date on 26 January, is now essentially flat.
We need to distinguish technical and fundamental developments.
On the technical side, this Flash Crash is rooted in the volatility markets. Equity volatility has moved far more than any other financial variables over the past couple of days. In the past months short equity volatility strategies, which aim at producing extra-returns from selling volatility implied by the option market, have been very popular and packaged into actively traded Exchange Traded Products (ETPs). As equity markets started to turn down and implied volatility picked up on Friday 2 February, such products entered into “stop loss” mechanisms and became forced buyers of VIX futures, with flows accelerating after the close of the US cash equity market on Monday. This created a self-fulfilling spiral of increasing losses, resulting in further de-risking. The large rise in volatility sent a negative signal to CTAs (momentum funds) and systematic trading strategies, likely feeding the sell-off in global equity cash and futures markets. The turn in risk sentiment has, to a lower extent, propagated to other risk markets.
US High Yield spreads have widened some 34bp from the 26/01 lows (Barcap OAS up from 311bp to 345bp), still about 20bp below the 2017 average. The EMBI index (EM hard currency sovereign debt) has widened by a mere 15bp. European credit markets have offered even better resilience.
On the fundamental side, the bond sell-off in January planted the seeds of this global market rout. A change in supply-demand dynamics, solid global growth, nascent concerns about inflation and the removal of monetary policy accommodation are the main forces supporting our negative 2018 views on global government bonds. All those factors have played out in the significant rise in bond yields this year. The bond sell-off accelerated on Friday 2 February as the US employment report delivered positive surprises. Most importantly, wage growth (2.9% yoy) reached the highest level since 2009. Already US consumer price inflation for December surprised to the upside. As the bond sell-off gathered pace, implied rates volatility started to pick up, and this indeed was the mother of this market correction.
What are the implications for the markets and our investment strategy?
The immediate market outlook appears uncertain, as it is hard to grasp the chain effects that such sharp short-term correction can initiate. The AuM (Assets under Management) of structured products selling volatility have been mostly wiped out, and this should be a stabilising factor. Also bond yields have pulled back this week as investors have sought safety, and this self-adjusting mechanism may also support some stabilisation in equities. However keep in mind that global equity ETFs saw massive inflows in January (north of $100bn); a partial reversal of those flows may be seen in the near future. The fast money community (e.g. hedge funds) may also run for cover.
Finally the sharp rise in equity volatility may lead quantitative funds (eg. Risk Parity and Equity Vol Control funds) to deleverage and de-risk, causing further shortterm weakness in equities.
While this correction will provide buying opportunities for long-term investors like us, trying to catch the falling knife is a perilous exercise.
The events of the past few days offer lessons that can be used to navigate the difficult investment environment ahead of us:
- They remind investors that the market structure has weakened. Investment banks have shrunk their trading books; regulation has made long-term investors more sensitive to mark-to-market fluctuations; systematic strategies expose global markets more frequently to sharp and self-sustained corrections; passive investment has grown sharply, including in sectors traditionally less liquid like High Yield credit, making the exit doors too small when sentiment turns. Record leverage in the non-financial sector (government, households and corporates) creates another point of fragility. In this context agility is of the essence: diversification, hedging and tactical allocation are key to the investment process.
- This cycle is now past the lows in financial volatilities. 2017 was about strong growth, low inflation and ‘permanently’ cautious central banks. 2018 will see a pick-up in cyclical inflation pressures and a broader central bank move towards the ‘exit’. The path to an orderly removal of extraordinary policy accommodation is narrow and leaves little room for errors.
- At the same time, especially as a long-term investor, we must acknowledge that there was no negative news on the financial, macroeconomic or political side triggering the price action we observed. Indeed the opposite is true, with economic activity indicators pointing to further acceleration and synchronized global growth. Also the pickup in interest rates is driven by positive economic fundamentals, including an expected normalization of monetary policy which has been ultra-accommodative for a long period.
- The valuation of many financial assets is somewhat stretched and exposed to a normalisation in real bond yields. Total returns going forward will be lower than they have been over the past decade.
- We retain a defensive view towards Fixed Income markets: the short-term pullback in government bonds will be a selling opportunity.
- On equities, we continue to expect low but positive returns for equities this year (about flat in the US, +56% in the euro area). The recent sell-off follows signs of exuberance in January but is most likely not the start of a bear market. Our central scenario remains unchanged, as the growth and earnings outlook remains buoyant, notwithstanding the recent deterioration in financial conditions. Equity sector correlation has declined sharply, making diversification, sector and stock picking particularly important.
- Other selected risky assets appear relatively safe, e.g. spreads in European Investment Grade should remain very contained as the technical support from the ECB is alive and well.
- The main fundamental risk, by far, lies in upsides inflation surprises. US inflation consistently surprised to the downside last year, and now seems to be turning up. Even in Europe, we see leading inflation indicators pointing to the upside. A rise in inflation would make central banks less dovish, forcing them to accelerate the removal of policy accommodation. This would push the (still very depressed) real long-term rates to the upside, potentially hurting valuation across asset classes.
- While the focus just now is on equity volatility, rates volatility is the metrics that global investors need to watch in 2018. Rates volatility has picked up from record low levels over the past week, but remains very subdued by historical standards. We will treat any significant pickup in rates volatility this year as a trigger to reduce risk positions.
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