By Tyler Durden
While his recent warnings about a return to market turbulence may have fizzled as a result of another unprecedented recent round of central bank intervention, by both the BOE and BOJ, who expanded their asset purchase programs to corporate bonds and doubling ETF monetizations, respectively while scapegoating Brexit, the period of calm is ending, and moments ago JPM’s head quant Marko Kolanovic has released a new report, according to which the recent period of eerie, record calm across asset classes is about to end, warning that “we expect a significant increase in realized volatility, correlations and tail risk in September and October.”
According to Kolanovic while a driver of the recent market stability the “relatively stable macro data and a seasonal decline in trading activity” he explains that “a significant driver of the volatility collapse was derivatives hedging effects, also known as pinning”, as well as the near all-time high leverage for Volatility Targeting and Risk Parity strategies. However, “this is all about to change as a number of important catalysts materialize this month (ECB, BOJ, Fed meetings), seasonals push market volatility higher, and leverage in systematic strategies and option positioning provide fuel for volatility.”
He also notes that normalization of monetary policy, rather than the current level of accommodative policy, poses a systemic risk for the market and could cut stock gains by 20% over the next three years:
How will the headwind of policy normalization impact these markets? This depends on the pace of normalization and any feedback loop with the economic cycle. For instance, if central banks normalize policy very gradually over 3 years and the economy doesn’t stall, one could see near-zero returns for equities over that time period.The rationale is that the average historical return on equities of ~7% would be erased by the withdrawal of CB liquidity (~20% over 3 years).
Kolanovic also adds that monetary policies are likely responsible for a 21% gain in low-vol equities, a 19% gain in DM equities, a 10% gain in government bond indices, and 7% of gold’s increase.
The quant notes that the only positives for stocks in September are the low exposure of long- short hedge funds, and that equity momentum would only turn fully negative below ~2000 on the S&P 500.
What is most disturbing, however, is that according to Kolanovic, the market would need to move only 1-2% lower for option hedging to push volatility higher.
“More concerning than the level of cross-asset correlations, is how quickly they have been changing over recent past months”; large instability of correlations makes it harder to forecast and hedge risk for a multi-asset portfolio and strategies such as risk parity.”
The only question is whether he is right.
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His full thoughts:
As market volatility plummeted, investors added to option protection and moved (struck) it closer to current price level. The market would need to move only 1-2% lower for option hedging to push volatility higher (as opposed to suppressing it, which was the case past 2 months). Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure. Our estimate of equity exposure for these strategies is shown in Figure 1.
Record leverage in these strategies and option hedging could push the market lower and volatility higher, if there is an initial catalyst to increase volatility. In fact, we may not even need a specific catalyst, apart from the seasonal increase in market volatility which is typical for September and October. Figure 2 above shows that equity volatility tends to increase by ~20-30% in September and October (September also tends to be the worst performing month, with an average -1% return). This seasonality is also present after removing prominent outliers (e.g. 2001, 2008, 2011, and 2015). When it comes to deleveraging of systematic strategies, even this seasonal increase in realized volatility would produce outflows of ~$100bn, which could push the market lower.
It seems that equity long-short investors are already anticipating a potential weak September, as their equity exposure (equity beta) declined over the past month. The low exposure of long-short hedge funds, and the fact that equity momentum would only turn fully negative below ~2000 on the S&P 500, are the only two positives we see for the market going into September.
It’s not just the threat of a quant-deleveraging, noted recently by Bank of America, that keeps Kolanovic on his toes. He says that “a more troubling development would be if data from central banks (ECB, BOJ and Fed) signal monetary policy tightening” noting that “this could result in a significant selloff across asset classes.”
We believe that CBs will stay accommodative (e.g. no September Fed hike, accommodative ECB/BOJ) and hence this negative scenario will likely not materialize. To look for indications of such negative developments, many investors started monitoring cross-asset correlations. These correlations recently increased to near-record levels (Figure 3, and for a primer please see our report Rise of Cross-Asset Correlations). We want to make few observations about cross-asset correlations that perhaps make this recent rise less alarming. First, most cross-asset correlation measures incorporate bond-equity correlation with a negative sign (equivalently, rate-equity correlation has a positive sign, i.e. correlation spikes in risk-off events when bonds and equities move in opposite direction). A potential tail event driven by central banks would happen if bonds and equities drop together. Also, cross-asset correlation measures are backward looking – the current near-record level of cross-asset correlation can in part be explained by a sharp move of risk assets (and bond rally) during Brexit. Indeed, over the past few weeks, cross-asset correlations have started declining.
The risk of risk-parity deleveraging as a result of a spike in cross-asset corrlations was discussed one month ago by BofA, in an article we wrote explaining “What Would Prompt Another “Risk-Parity” Blow Up” with Kolanovic piggybacking on this theme. But there’s more:
More concerning than the level of cross-asset correlations, is how quickly they have been changing over recent past months. This large instability of correlations makes it harder to forecast and hedge risk for a multi-asset portfolio and strategies such as risk parity. For example, rate-equity correlation spiked on Brexit to +90%, and then dropped below 0 (with resurfacing fears of CB normalization). High levels of rate equity correlation help strategies like risk parity and volatility targeting, and negative correlation is harmful. Similarly, correlation of FX to equities (e.g. EUR/USD vs. S&P 500) spiked to +75% on Brexit and then quickly dropped to -60%. Average stock correlation spiked to +70% on Brexit and then declined to only 10% in August. These record swings in the levels of cross-asset correlation point to a high level of macro uncertainty which makes asset allocation difficult.
So what is Marko’s recommendation for those who wish to avoid what may be another significant spike in volatility?
Clients who want to hedge levels of cross-asset correlation can invest in gold – over the past 10 years, gold returns were ~45% correlated to changes in cross-asset correlation (Figure 3).
To be sure, there is one simple alternative that would once again collapse the volatile scenario envisioned by the JPM quant: all it would take, is for central bankers to not engage in any risky, renormalization, which is the core catalyst that would topple the house of cards over.
Which is why Kolanovic concludes with this simple prediction:
“even a simple analysis shows that any benefit from higher yields would be more than offset by negative price impacts on bonds and other risky assets. Given these considerations, we think that central banks will not move towards normalization any time soon (e.g. no Fed hike in September)“
Of course, this also means that central banks are effectively forever “trapped” into pushing risk assets forever higher, with the increasingly unpalatable social side effects of rising violence, discontent and general revulsion at a system that has become clear to all caters to just the narrowest, and wealthiest, subset of the population.