Gandalf is back.
A couple of weeks after retracting (at least partially) his “buy every dip” reco, JPMorgan’s quant “wizard” (who, you’re reminded, rose to fame after blaming systematic strats for the meltdown that occurred on the morning of August 24, 2015), is back outlining “what might make volatility explode.”
You’ll recall that you don’t want vol to explode, because if it does, you’ll get deleveraging from the programmatic folks who have used low vol to lever up. So any reversal of that could exacerbate a drawdown.
Here’s Bloomberg with a summary of Kolanovic’s latest.
“Volatility will not explode on its own” as, for example, something like $50 billion in potential outflows due to seasonality won’t likely be a match for ~10 times greater ECB and BOJ bond inflows, JPM strategist Marko Kolanovic writes in a note; a sharp rise in volatility would require stronger catalysts or a combination of a few catalysts.
- Short-term risks like the French election and Syria are fading, putting the focus back on central banks
- “A potential risk-off scenario could be a combination of macroeconomic data slowing, but the Fed proceeding with normalization”
- Modest economic slowdown and/or Fed tightening are unlikely to tip the market by themselves, though if these come in a seasonally weak period and if they trip some volatility-sensitive strategies, the “increase in volatility could be more substantial”
- Investors should “closely monitor incoming macro data” including U.S. monthly payrolls report May 5
- U.S. tax reform is an “asymmetric catalyst with risks skewed to the upside”; market prices in a low probability of tax reform
Seasonality of Equity Flows: While the mantra ‘Sell in May and go away’ is frequently repeated, there is no consensus on how seriously investors should take this advice. We tried to look beyond performance statistics, and quantify seasonal behavior of investors’ flows.
What is driving this seasonality of investor flows? Early in the year, portfolio rebalancing often results in taking more risk (e.g. January small cap effect, seasonal Value rally, etc.). Inflows in retirement accounts are likely to increase early in the year as well (catch-up contributions to IRAs, funding of 401Ks). Some portion of tax refunds is also likely to end up in the stock market (e.g. ~48% of tax refunds are planned to be used towards savings). Hedge Fund equity positions, as well as buy-back activity show similar seasonal patterns. For instance, the HF equity beta increases steadily from January to May, and then declines. Corporate buyback announcements peak in the first and last quarter of the year (and executed buybacks accelerate Jan-May, flatten out May-September, and re-accelerate September to year end).
Aggregating estimates of these various flows, we conclude that the market is expected on average a ~$100bn tailwind of inflows in January to May, which turns into a ~$50bn headwind of outflows from May to October. This flow seasonality is not negligible and investors should take it into account along with other market considerations.
What will happen to Market Volatility: Market volatility is near all-time lows. The main drivers of low volatility are the currently low level of correlations, supply of options through risk premia products, and impact of option (gamma) hedging that is suppressing realized volatility. Following the March option expiry and ahead of French elections, positioning reversed leading to a short lived increase of volatility. This has now fizzled out in the aftermath of the 1st round of elections.
Selling of volatility is one of the key parts of risk premia/smart beta programs. Our estimate is that ~20% of risk premia strategies are allocated to selling volatility across asset classes (and about half of volatility selling is via Equity options). Selling of volatility is a yield generating strategy that can be benchmarked against bond yields. Hence declining bond yields invite more option selling activity. Increased supply of options also suppresses market realized volatility through hedging activity. The key risks of option selling programs is market crash risk. If one believes there’s a reduced probability of a market crash, volatility selling strategies look even more attractive. Global central banks have helped in both aspects by lowering yields and reducing crash risks. Indirectly, central banks have managed market volatility over the past decade.
One can see that in the 2007-2013 time period, central bank asset purchases closely followed market volatility (see crises in 2008-2009, 2010, and 2011).
This level of correlation to market volatility gave confidence to volatility sellers. The large QE3 program (Sep 2012 — Oct 2014), was enacted during a period of improved macro outlook and declining volatility. This was the first disconnect between central bank purchases and market risk. QE3 coincided with a ~43% rally in the S&P 500. Due to declining volatility, the S&P 500 Sharpe ratio was above 2 in 2013 and 2014 (for comparison, e.g. S&P 500 increased ten times more than the ~4.3% increase in hourly wages). As the Fed exited QE3, the BOJ and ECB stepped in aggressively in 2015. There were concerns about China, there was Brexit and the US elections, but the gap between macro risk (as measured by market volatility) and central bank purchases kept on widening. This brings us to the current wide gap — with a near record pace of central bank balance sheet expansion (highest since 2011) and record low levels of market volatility. This has further emboldened volatility sellers and other strategies that increase leverage based on market volatility (e.g. Volatility Targeting, etc.).
At this junction, the key question is when and how will this end. Will volatility just grind higher as the central banks start normalizing, or will it explode and wipe out some volatility sellers and levered strategies. We think volatility will not explode on its own. For instance, ~$50bn of potential outflows due to seasonality is likely not a match to the ~10 times higher ECB and BOJ bond inflows. A sharp increase of volatility will require stronger catalysts or a combination of few catalysts. Some thoughts on this are shared below.
Near-term Catalysts: With the French election results almost certain, renewed dialogue between the US and Russia on Syria, and North Korea tensions elevated but steady, the short term risks we highlighted last month are fading. The focus is now back on central banks, with the probability of a June 14th hike rising after the FOMC meeting yesterday (probability now at ~80%). A potential risk-off scenario could be a combination of macroeconomic data slowing, but the Fed proceeding with normalization. Neither a modest macro slowdown nor Fed tightening are likely to tip over the market on its own. However, if it happens in the seasonally weak time period, and if it trips up some of the volatility sensitive strategies (e.g. volatility selling, volatility targeting, etc.) increase of volatility could be more substantial. For these reasons investors should closely monitor incoming macro data such as tomorrow’s payrolls.
There are also positive catalysts that could lead to the market moving higher. The US earnings season was positive, and the market currently prices in a very low probability of US tax reform. Many stocks that would benefit from the pro-business policies of the current administration (such as tax beneficiary stocks, deregulation beneficiaries, etc.) gave back almost all their post-election outperformance relative to the market. US tax reform is therefore an asymmetric catalyst with risk skewed to the upside.