On Monday evening I flagged a piece out from Morgan Stanley, whose Andrew Sheets and co. note that large equity drawdowns are not, contrary to popular belief, tail events.
“Start at any date since 1950,and the likelihood of the S&P 500 being 15%+ lower after 12 months is 8%,” the team wrote, before cautioning that “that ignores an important scenario.”
“What,” Sheets asks, “if stocks drop more than 15%, only to recover before the year is out?”
Well as it turns out, the answer is that the likelihood of a 15% selloff rises to ~18%.
What I didn’t mention in the short post linked above, is that Morgan still prefers equities to credit in the current environment. To those who frequent these pages, that likely won’t come as a surprise.
Morgan has been warning about richness in credit for months and I’ve often cited their analysis in my own posts. Indeed I’ve said repeatedly that when it comes to tranquil markets and rampant complacency, there’s no asset class that looks more dangerous than credit. If stocks are asleep, credit is passed the f*ck out drunk.
Recall the following chart from Barclays:
That’s what you call “asleep at the wheel.”
Since the deflationary doldrums of February 2016, both IG and HY have seen remarkable spread compression. Both cash and synthetic are exceptionally rich.
Given all of that, and given the low vol environment in both equities and credit, consider the following excerpts from the same note cited above.
Via Morgan Stanley
The analysis above suggests that the risk of a severe equities decline over the next 12 months is about average. That’s notable, insomuch as we think many assume it is lower. At the same time, we also see a credible bull case centered on more greed,and animal spirits, in the near term. We think that credit underprices the former, while equity volatility underprices the latter, and this drives our views:
- Preference for equities over credit: With credit being one of the ‘most relaxed’ risk measures with regards to drawdown risk, we think this makes it an attractive place to hedge. We see a micro story as well,given balance sheet gearing near cycle highs. This leads us to prefer equities over credit, an allocation which also benefits from the former being more leveraged to the ‘sparkle’ trade.
- Own volatility, upside in stocks: Below-average levels of US equity volatility are not consistent with ‘average’ levels of drawdown risk, or elevated risks of an upside ‘boom’ scenario. We think that replacing US equity exposure with calls is an attractive way to take advantage of low volatility, steep skew and a wide range of outcomes.
- Own volatility, downside in credit: Similar to stocks, credit volatility is low,and we see HY risk reversals as an attractive way to hedge what we think is asymmetric risk to the downside. Selling high yield or loan total return swaps is another strategy our credit strategists believe make sense.