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A Step-up
In Volatility

Pascal Blackburne & Luc Synaeghel 2018-03-01

What if the early February episode of market stress was not just a “healthy correction” within equities’ relentless upward march, but rather the onset of a more troubled environment?

Although stock indices did recoup much of their losses over the following weeks, they came under pressure again at the close of February, quite possibly due to month-end rebalancing. A step-up in market volatility (the variable that is widely used to gauge portfolio risk) mechanically drives computer-aided fund managers to adjust their mix –equities, bonds, cash – so as to maintain a constant risk-return profile.

From a technical standpoint, failure of stock indices to recoup at least 50% of their losses, and remain above that level, would be worrisome. More fundamentally, signs of danger abound. The challenge of normalizing monetary policy across the globe, Federal Reserve in lead, after years of artificially cheap money is one of them. The comeback of inflation, also mainly a US issue at this point but set to spread to the Old Continent, is another, particularly if the dollar strengthens and Europe loses its currency buffer to higher commodity prices.

On that count, the Middle Eastern geopolitical situation is certainly disturbing. Syria has in effect become the scene of proxy wars between Russia, Iran, Turkey, Saudi Arabia and the US – with Israel increasingly likely to enter the fray. Another proxy war is being fought between Iran and Saudi Arabia in Yemen. Yet, despite many of these countries being important oil producers, the oil price is range-bound (USD 60-65 per WTI barrel). Weekly US inventory data appears to matter more than global supply-demand considerations. Analysts waste time and energy trying to “guesstimate” the weekly level of US oil stocks, itself a worthless figure (since very volatile and usually prone to later corrections), in order to speculate on short-term oil price movements – completely disregarding geopolitical risks in the process.

European political risk is being similarly ignored by financial markets, or at least downplayed. Admittedly, the elections that were so feared at the onset of 2017 proved benign, not bringing anti-European Union (EU) personalities to power. As a result, though, the governments in place are weak (France excepted) and face strong internal opposition. Germany has just managed, after months of arduous negotiations, to achieve a grand coalition. Given the divergences across the parties involved, odds are that little will be delivered, and that Germany will not take the lead in EU matters. Meanwhile, Brexit talks are proving difficult and Italian voters have delivered a blocked outcome, with in our view the only possible – but unlikely – majority consisting in an alliance between the Five Star Movement and the Centre-left. These may not be that far apart from a purely political stance, but their views on the EU are certainly diametrically opposed.

And then there is the latest Trump card: the imposition of tariffs on steel and aluminium imports. Worse, hearing of potential retaliatory measures by Europe and China, the US President twitted about taxing imports of European cars. Economists are unanimous in warning about the economic growth and inflationary costs of a trade war. Yet markets have barely reacted. It would seem that the early February wake-up call was not sufficient to break investor (low risk) habits.

Short volatility investors running for cover

The widely publicized implosion of Credit Suisse’s short-volatility exchange-traded note, which went from topping USD 2 billion late January to being liquidated days later, after a 90% price collapse, was just the peak of the iceberg. The pain inflicted by the early February spike in volatility must have been widespread, so convinced investors had become that volatility (just like inflation) was gone forever. Put differently, eerily calm financial markets in 2017 had made shorting volatility the “trade of the year”.

The reversal of such trades certainly proved brutal on that first Monday, February 5, amplifying the stock market correction. But, judging by the level of short interest accumulated on VIX futures throughout 2017, the process of short covering has further to run.

Chart 1: Net speculative positions on VIX Futures

int.rates

Source : Bloomberg

Note that volatility also stepped up in fixed income markets, meaning that the “standard” stock to bond reallocation might be disrupted – leaving cash as the only true risk-free alternative?

Defining risk, beyond beta and volatility

Reflecting on the sequence of events in early February, we believe that two important lessons can be drawn.

First, a relatively modest rise in interest rates (the 10-year US Treasury yield went up by 45 basis points during the month of January) led to a 10% drop in equities. The fact that a limited upmove in rates can wreak such havoc underscores how dangerous the stock market environment has become. This is certainly no time for complacency.

Secondly, in such episodes of stress, equities get sold indiscriminately, regardless of their fundamentals. Worst hit are the so-called “high beta” stocks – beta being a measure of the tendency of a security to respond to swings in the market. As such, one of our main thematic convictions, shale oil producers, came under severe pressure, with limited liquidity proving an additional handicap in some cases.

To us, however, risk should not only be defined as beta or volatility. We invest in attractive businesses for the longer term (and accept the short-term volatility in their stock prices) in order to achieve a good return. In selecting companies, fundamental analysis is thus paramount. We look for improving industries, where demand is set to outstrip supply – which will be the case in 2018 for both the oil and dry bulk vessel markets. We then strive to identify companies that have the financial and management strength to emerge as winners, as well as reasonable valuations – favouring a diversified basket approach. And we build positions with a long-term perspective – taking advantage of pullbacks to add to exposure.

Shale oil producers and bulk shippers may be high-beta (volatile) stocks, but we currently see them as a lower risk investment than many of the large cap blue-chip names, thanks to their strong earnings prospects and attractive valuations.