Is the worst over?
That’s the question on the lips of most market participants following the worst week for US equities since the crisis, a stretch that included another “worst since 1987” day, found the commercial paper market frozen and witnessed the Fed being forced to backstop money market funds and expand swap lines beyond the G-7 in order to prevent a public health crisis from morphing into another financial meltdown.
The answer to the question is: It depends.
If you’re asking whether the worst is over on the COVID-19 front, the answer is unequivocally “no”. CNN is now running a real-time ticker tracking the US infection total, if that tells you anything.
If you’re asking whether the worst is over the economy, the answer is also an unequivocal “no”. Most major banks are predicting an unprecedented collapse in US economic activity in the second quarter.
If, however, you’re asking about markets, the answer is “maybe” – at least in the near-term and contingent on there not being some kind of dramatic headline that suggests the virus situation has taken some unexpected turn for the truly macabre.
On Thursday, in “Gamma Drop-Off Offers Hope, But Now We Know: The Babadook Is Real“, I went back over the dynamics that precipitated the worst VaR shock since Lehman, detailing how each cog in the liquidity-volatility-flows “doom loop” serves to perpetuate a self-fulfilling prophecy. To wit, from that linked note:
Every aspect of the “doom loop” ghost story – from dealer hedging flows exacerbating swings to CTAs piling on, propagating their own negative momentum to vol.-targeting funds de-leveraging as trailing realized is pulled higher to risk parity unwinds in the final, nauseating act as cross-asset correlations “go to 1”, so to speak – was realized at one time or another over the past 30 days.
That loop is turbocharged by the inverse correlation between volatility and market depth. As the former rises, the latter becomes impaired, which in turn amplifies the effect of a given buy/sell flow on prices, leading to wild swings. Perhaps the most dramatic example of this is the simplest: For the first time since 1929, investors witnessed three consecutive sessions of US stocks swinging 9% in either direction.
I’d be remiss not to note that JPMorgan’s Marko Kolanovic has been predicting this for years – literally.
Although Kolanovic detailed all of these dynamics in his research long before most readers were familiar with his name, he spelled it out virtually word-for-word in September of 2018 as part of a much longer, department-wide GFC retrospective a decade on from the financial crisis.
The section of that report penned by Kolanovic was called “What will the next crisis look like?” and, again, the themes were familiar to those who have followed his career.
Kolanovic dubbed the next theoretical crisis (which is no longer “theoretical”) the “GLC” or, the “Great Liquidity Crisis”. Marko said it would stem from (and be defined by) some, if not all, of the following developments:
- Shift from Active to Passive Investment.
- Increased AUM of strategies that sell on “autopilot.”
- Trends in liquidity provision
- Miscalculation of portfolio risk.
- Tail risk of private assets.
- Valuation excesses.
- Rise of populism, protectionism, and trade wars
Does any of that sound familiar to you?
It’s important to note (and you can read my full take in the linked post here) that Kolanovic wasn’t predicting a crisis at that time. He was simply sketching what the characteristics of the next meltdown would be. Here are two highly prescient excerpts from the “GLC” note, dated September 4, 2018:
Increased AUM of strategies that sell on “autopilot.” Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~US$1 trillion over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.
Trends in liquidity provision. The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. In market making, this has been a shift from human market makers that are slower and often rely on valuations (reversion) to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day volatility, but it increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014, and August 2015.
Regular readers don’t need me to tell you this, but those dynamics were on full display over the past three weeks.
In his latest note, Kolanovic calls this “a historic time”.
“Market depth has virtually disappeared (~90% decline relative to the past year average), and gamma hedging (index options, levered ETFs, etc.) and systematic flows have produced a market that regularly moves ~10%, pushing the VIX to all-time highs”, he writes, adding that “the VIX at record highs in turn has prompted machines to pull liquidity, triggering a vicious feedback loop of volatility, illiquidity and outflows, and created the Great Liquidity Crisis we outlined as a scenario previously”.
He is referring to the September 4, 2018, note cited above, and he reminds you that this was always a possibility.
“Many aspects of this crisis have played out in-line with our prediction: severe liquidity disruptions, forced de-leveraging of systematic strategies, record speed of equity declines, and failure of bonds to offset equity losses”, he says, on the way to briefly recapping the gamma-driven “chop” discussed in these pages dozens upon dozens of times this month and last. To wit, from Marko:
Given that liquidity is now worse than [previous similar episodes], instead of moving +5% and -5% in alternate days, we have seen mind-blowing +10% and -10% moves on little to no fundamental news. The pattern works as follows – market moves (up or down) ~5%, and that prompts massive short convexity flows to push another ~5% in the same direction. As the convexity flows create a temporary market impact, the next day there is a reversion as the market returns to its fundamental clearing point. So it reverts (a large part of) the gamma move, but that triggers another round of short convexity flows that push it all the way back to the starting point of previous day.
In Thursday’s “gamma drop-off” post (the first linked piece above), I noted that, on Nomura’s latest assessment of options Greeks, the bank sees scope for a good portion of $Gamma in SPX/SPY to drop off. In a Friday note, the bank’s Charlie McElligott put the “drop off” amount at “upwards of 39%”, and reiterated that if we do in fact see some of the short gamma phenomenon that’s played such a key role in exacerbating price action “clear” (as it were), it could potentially mean calmer waters ahead.
“This would eliminate a significant portion of the dealer hedging flow which has contributed to the ‘negative convexity’-like violence of moves, particularly, forcibly selling into selloffs, but also too buying highs”, McElligott says.
Kolanovic underscores the point. “On the structural flow side, we think conditions will however improve”, he writes, adding that “with large option expiry, a meaningful portion (~1/3) of short gamma will expire [which] should reduce the chop and volatility going forward”.
You should also note that at this juncture, systematic deleveraging has mostly run its course. As McElligott puts it, “there’s nothing left to sell” is the “theme” for vol.-control. Here’s an updated visual on the vol.-targeting crowd’s exposure, which was pared down dramatically over the course of the rout:
Kolanovic describes vol.-targeting exposure as sitting at “cycle lows”.
So, what about active managers, risk party and CTAs?
When it comes to hedge funds and CTA Trend, Marko writes that hedge fund beta is “close to zero (in the 4th percentile) and CTAs short”.
In his Friday note, McElligott says his proxy for active manager exposure to US equities “printed lows last made in 2011 and 2014” earlier this week. “[At] a -3 z-score ranking since 2011”, active manager exposure on Charlie’s model is now in line with risk parity and CTA S&P 500 exposure, which are are “both at -3 z-score S&P exposures over the same period”.
“[They’re] more likely to be ‘adding’ versus ‘reducing’ here”, McElligott says.
And don’t forget about expected rebalancing flows. After all, this has been an absolutely egregious month for stocks, with SPX -22% and -29% on the quarter.
“Month- and quarter- end will merit an enormous pension rebalance flow on account of the impossible performance spread between bonds and stocks”, Charlie writes. Have a look at this:
That’s what he means by “impossible” – bonds’ outperformance this quarter is a 0.7%ile outcome, going all the way back to 1982. There are now estimates that the rebalancing flow could be on the order of $120 billion-$200 billion (to buy, obviously) in equities.
Those “old” enough to remember 2018 might recall that the worst December since the Great Depression for US stocks probably would have been even worse were it not for a historic rebalancing flow. Part of the reason why that flow catapulted stocks to the extent it did was that liquidity was so poor. This time, that dynamic could be even more dramatic.
Fixed-weight asset allocators are around 4% underweight equities right now on JPMorgan’s models, and as Kolanovic writes, “given the record low liquidity and compounding effect of short gamma, the impact [of the rebalancing flow] could be up to 4x times larger”. He notes that in December of 2018, it was 2x the bank’s model estimate “with the VIX at less than half its current level”.
Of course, all of this depends on the evolution (and in this case, you can take “evolution” both figuratively and literally) of the virus, which is inherently unpredictable.
On Friday, above the usual auto-generated signature, McElligott personally signed his note as follows: “Enjoy the weekend with your families. Please be safe. -Charlie”