Signs of market complacency in 2018
Last year, there were several signs of market complacency suggesting that investors should fear a sudden rise in price volatility. For instance, one indicator we like to watch is the Economic Policy Uncertainty (EPU) index developed by Bloom Baker and Davies (2016), which is a measure of economic uncertainty based on newspaper coverage frequency. After the liquidity event in February, we saw a significant divergence between the EPU index and the VIX in the following months (figure 1, left frame). It looks like the February spike in volatility was considered as a good opportunity to short the VIX at higher level in order to capture an interesting premium. According to the CFTC data, we can notice in figure 1 (right frame) that the net short interest grew considerably between March and October.
Another interesting indicator to watch in periods of compressed volatility is the behavior of the SKEW index relative to the VIX. Following the crash of October 1987, investors realized that the tail risk in the equity market (returns under 2 or more standard deviations below the mean) is significantly greater than under a log-normal distribution. Therefore, the SKEW index, which looks at the tail risk via OTM options, has become a popular indicator to watch. Figure 2 shows that a sustained period of falling VIX combined with a rising SKEW (demand for ‘crash’ protection) is usually followed by a sudden rise in price volatility, especially in periods of high uncertainty. Between March and October, we can notice that the VIX was trading in the low 10s while the SKEW rose above 150, which was clearly a warning signal.
Falling Global Liquidity Weighing on equities
Last year was also marked by the collapse in global liquidity, which should have pushed investors to deleverage their exposure from risky assets such as equities. With the Fed shrinking the size of its balance sheet and the ECB exiting QE, the YoY change in the top central banks’ total assets was going to switch to negative for the first time in years (figure 3, left frame). In addition, we can notice that the annual change in central banks’ assets tends to lead (12M Lead) the annual performance of global equities (figure 3, right frame); therefore, global quantitative tightening was going to pressure equities’ performance to the downside.
In addition, real money growth, computed as the difference between M1 and CPI inflation, has been plunging in recent years for most of the developed economies. Figure 4 (left frame) shows that our global real M1 indicator tends to lead also equities’ performance in the 9 months to come. We can see periods of important divergence between the two times series, however falling real money growth tends to weigh on equities in the long run.
Figure 4 (right frame) also shows an interesting co-movement between the annual change in China Total Social Financing, a broader measure of credit, and the yearly change in global equities. The credit impulse in China has been contracting as the shadow banking activity has been collapsing and therefore also showed signs of potential weakness in risky assets.
The 2019 picture: Higher volatility, but higher equities?
With all our leading indicators going down combined with an elevated uncertainty, many investors have concluded that we are in the beginning of a LT bear market. Bridgewater CIO Greg Jensen recently mentioned that the growth slowdown will be worse than the market is currently expecting and that the Fed will have to prepare to start easing again. Chris Cole from Artemis also lately mentioned in an interesting podcast the impact of the 2-trillion US Dollars volatility trade unwind on markets, confirming that the higher volatility regime is just the beginning. If a USD 5bn crowded trade created a small impact in the equity market, what about the 2-trillion USD trade?
In addition, liquidity in futures disappeared when the volatility spiked in February and December, and therefore emphasize the risk of accelerated deleveraging. The little flash crash we saw on the Japanese yen on January 3rd shows how thin the liquidity is even in the FX market for a G3 currency.
Overall, the picture looks gloomy and we are clearly agreeing that equities are at risk in the medium term and that we have entered in a new regime of higher volatility. However, we could see equities reaching new highs even with a higher implied volatility and flat (or even negative) yield curve. For instance, while volatility started to rise in the late 90s and the 2Y10Y was approaching 0, equities continued their rally and almost doubled between 1997 and 2000 (S&P 500 index). Therefore, we could see a scenario ‘a la’ 1990s this year, but investors should just be ready to face recurrent periods of significant sell-offs.
We will carefully watch behavior of the yield curve this year; even though many economists are focused on the flattening of the yield curve, bear markets tend to be preceded by a sharp steepening of the 2Y10Y (figure 5, right frame).
Source: Eikon Reuters
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.