Yesterday, Jim Chanos took a break from the Yale CEO Summit in New York to chat with Sarah Eisen.
The interview played out against a somewhat bizarre set backdrop featuring a sad-looking Christmas tree and an accent table that someone threw a bedsheet over and adorned with a CNBC peacock. Here’s the clip:
So Chanos is worried about market “fragility” and he should be. It’s true that the February and October equity routs played out following bond selloffs and that clearly suggested that this is a market that cannot stomach rapidly rising yields. Indeed, a flip in the equity-rates correlation in and around those selloffs didn’t bode well for balanced portfolios and risk parity.
That said, the acute moves that transpired on February 5 and October 10 were the direct result of modern market structure gone awry. In both cases (and give me some rope here – enough to hang myself probably) rapidly rising yields flipped the stock-bond correlation and ultimately, systematic selling collided with option hedging effects and evaporating electronic liquidity (i.e., an acute lack of market depth) to catalyze harrowing selloffs.
This is well documented, and you can see it in the following set of visuals from Goldman’s Rocky Fishman:
Well, in a new note dated Thursday evening, Goldman takes a sweeping look at “the number of sharp moves across assets” which the bank warns are “rising” and have now reached levels near the sovereign debt crisis and the 2015-2016 yuan devaluation/deflation scare.
Clearly, the potential exists for more dramatic moves across assets considering the environment. The vaunted “Goldilocks” narrative of synchronous global growth and well-anchored inflation has given way to a new paradigm, defined by a global slowdown and rising inflation in the U.S. When you throw in ongoing efforts by developed market central banks to normalize policy and a hopelessly unpredictable geopolitical backdrop, you end up with an environment that’s ripe for “fragility” events.
Goldman notes that in this environment, it might be tempting to simply replicate the logic of risk parity by levering up low volatility assets. “Investors may be tempted to rescale higher return-to-vol investments in a risk-parity manner, creating ‘volatility equivalent’ allocations across assets”, the bank writes, before warning that “levering up the highest return-to-vol assets inherently neglects other risks an asset has, not captured by its historical volatility.”
In other words, it neglects tail risk.
This is especially critical now as cracks continue to emerge in credit and as pundits and high-profile names take to the airwaves to shout about the “BBB apocalypse” for IG, the late-cycle risks for HY and the bursting of the leveraged loan bubble.
“Although credit has low vol – in both total and excess return terms – it has the most negative skewness (which measures return asymmetry) and the highest kurtosis (which measures the frequency of large tail events) across assets”, Goldman observes, illustrating the point with the following chart.
And while tail events naturally tend to cluster around recessions, it is by no means safe to assume that in the absence of a technical recession, tail risk won’t come calling.
“For risky assets tail risks tend to rise most often around recessions, but a number of sharp tails have also happened outside of recession, especially for equities – for example during mid-cycle periods such as 1996, ‘98, 2002, ‘12, and ‘16”, Goldman continues, adding that “in general, this has tended to be associated with sharp declines in economic growth or movements to below 2% growth level.” What you’ll also note from the following visual is that HY volatility tends to spike dramatically as recession risk rises.
Next, Goldman outlines “the three aspects of tail risk” which are as follows:
- size (how deep are drawdowns),
- frequency (how often do they happen) and
- speed (how fast are drawdowns)
So, where are the drawdowns the deepest? Well, there’s some nuance there. Although a simple look at raw returns suggests that the largest daily losses occur in commodities, stripping out volatility differences by employing leverage shows “the size of the worst drawdowns in credit are much larger in comparison”, Goldman writes.
That’s not great news in the current environment when credit risk is the talk of the proverbial town. “Investors levering up credit to spend volatility risk budget may find they quickly exhaust whatever tail risk budget they have”, Goldman warns.
When you look at frequency, HY again comes up looking particularly susceptible to tail risk. “A daily 5% loss occurs, on average, in US HY credit once/year since 1990 but only once every 2 years for the S&P 500 and once only every 15 years for the US 10-year bond!”, Goldman exclaims, employing an exclamation point, something usually not seen in the bank’s notes.
Finally, on speed, Goldman delivers the nuance, and we’ll just use the longer quote here so as not to muddle the message. To wit:
The speed aspect of tail risk is more nuanced than size and frequency because it essentially asks over what horizon the size and frequency components are at work. In Exhibit 10 we do the same volatility equivalent max drawdown calculation as in Exhibit 6 above, but now for weekly and monthly returns. We see that ordering of tail risk over longer horizon returns is roughly preserved for credit (worst), government bonds (best) and equities (in between). We find a similar result doing the same volatility equivalent calculation as in Exhibit 8 above, but looking at how frequent weekly sell-offs of more than 10% and monthly sell-offs of more than 20% are (Exhibit 11). Again the tail risk ordering is roughly preserved, with credit remaining the most extreme and government bonds remaining the lowest.
In case it’s not clear enough, the message from Goldman is that while credit may exhibit an attractive-looking return-to-vol ratio, it hides “the worst tail risk.”
This analysis comes at a particularly inopportune time for credit. IG has become to a certain extent synonymous with macro-systemic risk and high yield is vulnerable to a turn in the cycle. At the same time, the price insensitive bid from the benefactors with the printing presses is evaporating, prompting a scramble back up the quality ladder that everyone spent the last nine years scrambling down.
You can take all of the above for what it’s worth, but the overarching point is that while “fragility” and “tail risk” are terms that are tossed about on a daily basis, there’s a lot of nuance in both. Understanding that nuance is going to be key as the QE/carry/easy money regime morphs into the QT/late-cycle dynamic.