Last week’s escalating tensions with North Korea rattled markets out of a summer lull. But did the spike in volatility reflect the fundamentals?
Following one of the calmest stretches for stocks since the 1960s, last week’s escalating war of words with North Korea hit late summer markets which had been priced for relatively little volatility. The result was sharp and sudden: a 70% rise in the Volatility Index (VIX) over three days, a 2% drop in global equities, and more than a few holidays disrupted.
While the ‘why’ is worth discussing, the more pressing question is what happens next. For several reasons, we view this as a ‘standard’ equity correction within an ongoing bull market. With volatility bearing the brunt of the repricing over the last several days, that’s where some of the most interesting changes lie.
It’s a fact of life: drawdowns happen. Since 1929, there’s always been a 30% chance that a 5%+ drop will occur at some point over the following three months. The S&P is off less than 2% from its all-time high, and (still) hasn’t seen a 5% correction since mid-2016, the longest such streak since 2004. Whether you’re bullish or bearish, I’d imagine there’s wide agreement that something like this would happen eventually. The bigger question is what’s driving the move. We don’t see it driven by a shift in fundamentals.
We continue to see solid global growth, which we believe will help to boost global equity earnings. These views didn’t change in the last week.
Let’s start with growth. Our economists continue to see solid global growth, which we believe will help to boost global equity earnings per share by double-digits this year. These views didn’t change in the last week, where, if anything second quarter earnings in developed markets continued to surprise to the upside. If that’s right, it represents a key difference from the larger August drawdowns of 2011 and 2015.
Policy also remains supportive, with real policy rates in G3 economies—U.S., Japan and the Euro area—still deeply negative. While there’s always a risk that the Fed’s upcoming conference in Jackson Hole will have a hawkish tone, that’s not our expectation and, if anything, our economists think the risk is tilted to European Central Bank President Mario Draghi sounding mildly dovish, given recent strength in the Euro. We forecast inflation to stay well below target across the G3 for another 4-5 months on our forecasts, providing flexibility to move policy slowly. Bigger risks loom next year, when higher inflation may take away this optionality.
Geopolitics is also fundamental. Relative to the five-year average, Korean credit default swaps, the cost of insuring against defaults, is 3 basis points (hundredths of a percentage point) higher while the Korean Won is 3% lower. Korean stocks remain up 16% year-to-date, although volatility has almost doubled. These indicators are worth watching, but in aggregate it is hard to say they’re discounting an alarming scenario.
So, if it’s less about fundamentals, maybe recent moves are more technical. August is a month when more investors are out (or about to be out), lowering risk appetite and thinning markets. Even if more people were in, the dust-up with Korea is a legitimately hard risk to discount.
And, as noted by Christopher Metli, in our Institutional Equity Division, there was an unusually high number of volatility shorts in the market heading into this week, which may help to explain (some of) the large swings in VIX. These moves have pushed the S&P 500 skew to its steepest levels on record.
All of this leads us to two paths. One is that the rise in volatility becomes self-fulfilling, with investors selling as volatility rises and markets move lower, driving more of both. For this risk, I’d be watching if new lows in the S&P 500 are confirmed by new highs in the VIX. This scenario is also scarier if realized volatility can stay near implied (if it doesn’t, implied volatility can fall, reversing the cycle). As of noon Friday, S&P 500 three month options were priced for a daily move of 0.8% and EuroStoxx was priced for a daily move of 0.9%.
The other path, more likely in our view, is that this turns out to be a more ‘normal’ correction. The Morgan Stanley Global Risk Demand Index (GRDI*) has fallen to -3.6, an ‘oversold’ level seen only a handful of times over the last eight years. The volatility term structure has inverted, which has also tended to be a reasonable indicator of elevated fear.
We think there is capacity to add exposure eventually, especially in the U.S., where Prime Brokerage tells me net leverage is in the 20th percentile. Given the steepness in skew, calls may offer some of the most attractive ways to be constructive on U.S. stocks., while put spreads may offer the best value for those looking to hedge what is still a relatively mild pullback. Overall, our positioning would remain constructive.
Is there an exception? We would not ‘buy the dip’ in U.S. credit, where my colleague Adam Richmond sees more risks, given weaker fundamentals, expensive pricing and limited upside in exchange for swimming against the recent tide.