Early Monday, I revisited “doom loop” dynamics.
A fixture of modern market structure is the interplay between volatility, flows and liquidity. As vol rises, liquidity tends to diminish and with it, the market’s capacity to absorb large trades without an outsized impact on prices.
Because vol’s the “exposure toggle” in modern markets, to quote Nomura’s Charlie McElligott, vol spikes are often accompanied by meaningful de-risking into an increasingly thin tape that’s less and less able to facilitate trades efficiently.
The result: Even larger price swings, higher vol and more mechanical de-leveraging, until there’s nothing left for systematics to sell. The good news currently is that we’re there, or nearly so: Systematics as a monolith don’t have much left to sell.
The figure above shows Nomura’s composite gauge of systematic exposure, which rolls up CTAs, vol control and risk parity.
As you can see, that metric now sits in just the 5%ile in the history of the series.
By cohort, vol control equity exposure’s just 3%ile on a 10-year lookback, CTA exposure 18%tile and risk parity 31%ile. The vol control de-leveraging looks like “elevator down” (figure on the left, below).
That’s courtesy of the vertical inflection in trailing realized, which is (obviously) 99%ile (figure on the right).
“Systematic positioning is extremely low / underweighted / short at just 5%ile combined in our data history,” McElligott said Monday. “So at the very least, this source of further ‘impulsive supply’ is incredibly diminished at this point of the drawdown.”
Thanks. Thus we rally.
Illiquidity works in both directions, it will be interesting to see what happens next.
Investors starting to bet on flurry of deals resulting in something like i) 10% tariffs on Everyone But China (EBC), ii) tariffs less than 145% and more than pre-4/2 levels on China (call it 50%?), iii) various industry specific tariffs (semis, pharma, etc), and lots of exemptions, pauses, delays, etc so that big, influential companies, industries, and interests don’t get crushed (what is big and influential enough unclear, but small biz and consumers probably don’t count).
As H says investors also think we know where put strikes are, on 10Y and SP500.
So we can focus on picking the names that will do well in that new cost/demand environment. Investors also think recession remains significant risk (prediction market odds just over 50%) so some recession-tolerance also good.
What’s risk to our new equanimity? Xi could say “nope, not taking 50%”, EU could say “nein to 10%” or “non to US beef”, investors could be surprised how much margins/earnings decline, Reps could figure out that 10%/50%/exemptions doesn’t raise enough tax revenue for tax cuts, etc.