Remember back on Tuesday night when Goldman decided 19 hours before the Fed hike was as good a time as any to downgrade US equities?…
Yeah, well while everyone else was focused on the headline (“big trees fall hard“, “downgrade equities to neutral,” etc. etc.) we skipped straight to what we thought was actually interesting in the note.
Or maybe it was only interesting to us, but whatever the case, we flagged the fact that about half way through the above-mentioned piece, Goldman went full-Marko, reiterating the message consistently delivered over the past several weeks by JP Morgan’s celebrated quant wizard Marko Kolanovic. Here’s what we said:
You know the name. He’s Gandalf. Nostra’quant’mus. JPMerlin.
If you frequent these pages, you’re well acquainted with Marko. He’s JPMorgan’s quant wiz and his star has risen over the past several years along with the market’s interest in the systematic strats he covers.
More specifically, Kolanovic likes to shed light on the shadowy corners of the market inhabited by programmatic “devils” like CTAs (the “trend followers”), risk parity (who is having a tough go of it as stock-bond return correlations become less negative), and vol targeting strats.
Essentially, the worry is that recent one-way market action has left the strats mentioned above all-in. And in the event something goes wrong, their deleveraging will make the pain all that much worse for the broad market.
Well on the eve of the Fed, Goldman is out with an exhaustive look across markets and here’s what the bank has to say about just this subject…
Low volatility and trending markets tend to attract systematic investors, whose size and impact has increased in recent years. CTAs (Commodity Trading Advisors) are trend-followers or momentum investors that mostly use futures – if the market shows a clear uptrend there is a strong chance that CTAs are long the market. The beta of two main indices tracking macro HFs and CTAs. to the S&P 500 has soared in recent months and is close to its highest levels since the 90s (Exhibit 16).
Another group of investors that are attracted by low volatility are risk parity funds (and possibly investors with volatility targets). They allocate to assets targeting risk levels, i.e., they invest based on the volatility. With the recent declines in equity volatility, also relative to more sticky rates volatility, risk parity funds have likely increased their equity exposure, too. Exhibit 17 shows what the relative equity allocation of a simple risk parity portfolio of S&P 500 and US 10-year bonds would be (using 3-month realised volatility to scale weights). In the event of a reversal of the trend, these systematic investors are likely to reduce equity exposure quickly, which could exacerbate an equity drawdown and result in a faster and larger volatility spike. ‘Vol of vol’ risk is higher, also owing to changes in regulation and market microstructure, which have reduced liquidity across assets.
In other words: Marko was right.
Of course equities didn’t sell off, so maybe Marko was wrong. Or maybe Goldman was wrong. Or maybe both Marko and Godlman will be right when the selling finally does start, vol spikes, and the systematic deleveraging begins in earnest. Who the f*ck knows.
But what we do know is that Marko was out yesterday with a new comment in which he notes that US equities are pricing virtually no knock-on risk from a potential adverse outcome in the French elections (how many times have we virtually begged you to look at the difference in the VSTOXX versus the S&P implied vol term structures, one being notably “kinky” and the other smooth?), as well as confirming that the Fed put and what we might call the “Trump pride backstop” are both still firmly in place.
Volatility to Increase: In our comment last month, we argued that market volatility will increase. Volatility nearly doubled, rising from ~4.5% during the month of February to ~9% month to date. However, for volatility to cause de-risking by systematic investors, the increase needs to extend in time or magnitude (as these investors typically look back ~2-3 months rather than just 1 month). In terms of fund flows, this week there was some additional buying on account of the monthly option roll, and next week we could see this reverse and additional equity outflows given the MTD and QTD rebalances. Our second concern surrounds the French elections next month. On our Global Markets conference in Paris last week, a survey of clients showed that only ~20% think that Le Pen may win (vs. 60% for Macron). Further complacency may set in in the aftermath of the Dutch elections yesterday, and US Equity markets (e.g. VIX) price virtually no event risk related to French election (in contrast to similar measures in Europe. We maintain that the increase in volatility will continue (e.g. due to change in option gamma), and that there will be an increase of uncertainty related to French elections. Near-term, market weakness is more likely than not. Clients have asked us ‘if everybody expects a correction, does that mean that it will not happen?’ Possibly, but our survey of clients last week shows that only 17% of them expect a correction.
Fed Put and Buying the Dip: Early this month, the Fed surprised the market by telegraphing a March hike. At the time, investors started speculating whether this was a sudden hawkish turn, or even a politically motivated decision. We think it might have been the move of a prudent monetary Dove. Hiking in March, gives the Fed the option to skip June should there be market turmoil (e.g. related to French elections). Indeed, the market-implied probability of a June hike dropped yesterday from 60% to 50%. After the dovish hike yesterday, extreme short positioning in bonds, and the selloff in rate sensitive assets (such as precious metals and REITs) snapped back. The short squeeze in these assets could have some momentum in the next several days. The dovish Fed outcome implies that the ‘Fed Put’ is likely still alive and well, so investors should buy on potential market weakness that we think could occur over the next month or so. This approach of buying on weakness is known as “BTD – Buy the Dip” (last two years virtually all of the market’s returns occurred one day after any the pullback i.e. ‘the Dip’). Success of the strategy is often attributed to the dovish resolve of central banks.
Trump Put: While the Fed put would disappear at higher rates, in less than a year the composition of Fed will be drastically different. In our report last month we pointed out that it likely means a Fed that has a higher tolerance for inflation, and favors a weaker USD and continuation of monetary accommodation. We think that it is a misconception that Republican nominees will be fiscally conservative (it is the party in opposition that becomes fiscally conservative). In addition to the Fed put, there is another driving force that can backstop a market selloff – we call it the ‘Trump Put’. Over the past weeks, the President has taken some pride and ownership in the rising US equity market. The market rally in the aftermath of the President’s address to Congress (March 1st), shows that it doesn’t take much to awaken the animal spirits of domestic investors. In the case of market weakness, there are a number of proposals and measures (such as Infrastructure, Deregulation, Tax Reform, Repatriation) that Trump could discuss and near-term back-stop the market. After all, assuming the full benefit of tax reform on 2018 earnings would justify the S&P 500 at meaningfully higher level than our current price target of 2400.
To summarize, short term we are cautious and suggest reducing or hedging US equities. To hedge upside risk, investors could also rotate from the US into Emerging Market equities (which offer a valuation buffer: EM equities are ~25% below, and S&P 500 is 80% above post-crisis 2011 highs). Any meaningful weakness (e.g. 5%), investors should likely use as a buying opportunity, i.e. continue to BTD.