Two Days of Market Turmoil—What Now?
After an unprecedented run of gains, global equity markets plunged last Friday (Feb. 2) and yesterday (Feb. 5). However, we believe the worst is behind us, as further explained below.
A quick recap:
- The S&P 500 fell 6.1% over the two trading days, while other global equity markets sold off in similar amounts.
- The yield on the 10-year U.S. Treasury initially rose by five basis points on Friday following strong wage growth data inside the payrolls report. However, the yield plummeted on Monday—by 14 basis points—amid a flight to safety in the wake of stock market losses.
- The biggest story has been resurgent volatility. The CBOE Volatility Index (VIX) soared from 13.5 on Thursday night to over 49 early Tuesday. On Monday alone, the VIX shot from 18 to 39—a 21-point move that represented the VIX’s largest-ever one-day rise (including any single day in 2008 during the financial crisis!).
A rapidly accelerating decline
Recently—including in our Fourth Quarter 2017 Report—we have noted the nature of some of the systematic risks embedded within investor positioning, crowded trades (such as short volatility), and security-specific risks that could lead to a negative feedback loop for equity prices. As we have said, these risks represented dry tinder or potential accelerants: Nothing about them would cause or create a sell-off, but once a sell-off began they would have the potential to exacerbate it.
That is exactly what happened on Monday, which saw:
1. Forced selling. Friday’s 2.1% selloff in the S&P 500 appeared to be sufficient to initiate some forced selling by systematic investment strategies such as risk parity, target volatility (big in the insurance space), trend following, and many varieties of “short volatility” strategies–including inverse-VIX exchange-traded products (ETPs). The magnitude of this selling pressure by these systematic strategies has been estimated to be between $100 billion to $200 billion in U.S. equities alone.
2. Technical fragility. The down equity/up VIX dynamic also brought into play a technical fragility associated with how inverse-VIX ETPs manage their portfolios. Essentially, they must buy VIX futures as the VIX rises. The VIX on Monday rose so much that these ETPs were forced to virtually liquidate themselves, purchasing around 200,000 VIX futures contracts to cover their short VIX futures positions. We understand those futures contracts represented approximately 95% of the assets of these ETPs.
The upshot: These ETPs now have only 5% of the assets in them as they had at the beginning of Monday!
- To provide some context, this is approximately 2.5 times as much “short volatility” exposure as Long Term Capital Management had in its portfolios when it blew up in 1998.
- Since these ETPs are now effectively liquidated, much of this specific risk has been relieved.
All told, the algorithmic selling by systematic strategies listed above combined with the very niche/specific/technical explanation for why the VIX exploded higher made for a very sharp correction in global equity markets on Friday and Monday.
Assessing risks to our portfolios
We have taken note of other markets and assets in an attempt to gauge the severity of the risks to our portfolios. Some observations:
- Credit markets barely noticed the events of the past few days, and remain very strong overall. High-yield spreads (as represented by the Markit CDX North America High Yield Index) widened by two basis points on Monday (from 3.33% to 3.35%), and investment-grade spreads behaved similarly. This is in stark contrast to the credit markets’ poor reactions to other “risk off” type events in the past.
- If there were global growth concerns, we would expect to see an input like copper sell off dramatically (as it did in 2008, when it fell 70% from 7/2/08 to 12/23/08). However, copper was down less than 1% on Monday.
- In 2008, it took a 24% decline in the S&P 500 (from 8/28 to 10/6/08) for the VIX to breach 50. On Monday, it took a 6% decline for the VIX to breach 50.
- U.S. Treasuries on Monday reacted in a historically “normal” fashion: Bond prices rose and yields fell as investors bought bonds in a flight to safety. As of Tuesday morning, however, yields are again on the rise in the U.S.—another signal that there are not persistent global growth concerns.
- Importantly, inflation expectations are not rising. For example, inflation swaps in the U.S. have not budged their pre-wage/payrolls number levels on Friday morning: 10-year inflation expectations were 2.34% on Thursday and stand at 2.33% as of this writing; 2-year inflation expectations were 2.11% on Thursday and are currently 2.06%.
Bottom line: We believe this is an incredibly specific/niche risk event focused on equity markets (mostly the U.S. market), brought about by the confluence of investor positioning, forced selling from systematic strategies, and very technical “short volatility” covering activity. Nothing fundamental about how companies will make money has changed. We expect the algorithmic selling to wane over the coming days. As that occurs, we believe there will be compelling buying opportunities as a result of this indiscriminate selling.
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