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CIO team, 06.02.2018
A sharp sell-off in Global Markets
The S&P500 is 8.1% down peak-to-trough and -0.9% YTD. Yesterday, the Index fell -4.1% and is now trading below its 50-day moving average.
The slump began last week due to a sharp rise in US 10-year Treasury yields above 2.8%. Yields surged on higher than excpected inflationary pressures emerging from the US jobs report. Although treasuries were up yesterday, the US indices accelerated their slump. The unwinding of short-volatility strategies caused a self-feeding negative mechanism.
This is a normal and overdue period of consolidation, although the rapidity of the pullback is fraying sentiment. Declines were widespread across asset classes, including credit and commodities.
Asian markets have followed with the Nikkei -4.7% this morning, the India Sensex down 3% at the time of writing and the Shanghai Composite Index – 2.9%. GCC markets are down 1 to 3% this morning. Year to date gains have been wiped out for most global equity indices.
Is this uncommon?
Flash crashes are not uncommon, corrections occur as a matter of course in bull markets. The last flash-crash on the S&P500 occurred on 6th May 2010, when the index swung -8.7% from high to low, now dubbed the ‘2010 flash-crash’. It is still debated as to why it happened.
The Brexit event triggered the GBP flash crash, 24 June 2016, when the GBP swung -11.9%, from high to low.
On average the S&P500 sees four 5% corrections every year and, though less frequent, 10% corrections are not an abnormal occurrence.
Equity Strategy – Post the Sell-off
There isn’t any concern around fundamentals, earnings and growth are still expected to be strong tailwinds. The earnings season is almost over and strong economic and earnings growth remain unchallenged.
Whilst, we had expected higher volatility and extreme pullbacks for the current year the actual speed could not be foreseen. January witnessed almost $100bn of flows into equity markets, a record and seen by some as a contrarian indicator.
We remain positive on the markets based on fundamentals and whilst we would not rush in to buy as we cannot predict whether the selloff is over or not, we stay with our conviction that systematically investing in quality stocks and in sectors and geographies with strong growth will generate returns. We do not expect a 2017-like heady +20% upside. However, we reiterate our call for high single-digit returns from DM equities and high-teen returns from EM stocks.
“Cautious Optimism” remains our Mantra for 2018.
Derivatives markets are crowded with short-volatility strategies. For instance a bet against equity turbulence with assets in related exchange-traded products estimated at $2-3bn had to be unwound, with the Vix Index jumping to 38.8 yesterday, its highest level since August 2015. This prompted many other investors with short volatility positions to cover their shorts. Hence, the major US indices plunged. At least two VIX-related ETPs stopped trading for over five minutes as volumes soared. And funds that went short continued to tumble in late trading with the VelocityShares Daily Inverse VIX Short-Term ETN down 84% from the close and the ProShares Short VIX Short-Term Futures ETF slumping 79%.
Chart 1: Volatility spikes after a year of record lows (CBOE Vix Index, 5 year)
Source: Bloomberg 6th Feb 18
However, according to some estimates the short volatility products should have covered 95% of their risk, meaning that the ‘VIX blowup’ should subside. Futures on the VIX are trading at 29.7 this morning, retreating from yesterday’s peak.
Fixed Income Strategy
Our fixed income strategy is unchanged. We expect modest upside pressure for DM Sovereign bond yields from current levels. We maintain a bias towards credit and in particular EM bonds. We expect US 10-year Treasury yields to trade in the 2.7%-3% range
Flight to Safety to US Treasuries back in Vogue. For how Long?
A flight to safety bid fuelled demand for US Treasury bonds yesterday. Yields on the benchmark US 10-year note gapped down to 2.70% from 2.88% overnight, following a sharp rise to a three-year high on increased concerns about inflation. Implied volatility on Treasuries surged to an eight-month high of 60.4bp on Monday, according to Bank of America Merrill Lynch’s MOVE index. Speculators last month increased short positions on the 10-year Treasury futures contracts to a record, hence crowded positioning might suggest the blow-off move on yields should not last long.
Emerging markets bonds and US high yields fared better and proved relatively resilient to the recent volatility bouts. The cost of protection against corporate defaults rose across the board as investors braced for hedges. The Markit CDX North America Investment Grade index rose 5.38bp to 56.15bp and the CDX high yield rose by 13bp to 335bp.
Chart 2: Investors scramble for protection on US Corporate IG and HY (Credit Default Swap)
Source: Bloomberg 6th Feb 18
Wealth Management – CIO Office.
Contact: +971 (0)4 609 3564
Anita Gupta – Head of Equity Strategy
Syed Yahya Sultan – Head of Fixed Income Strategy
Sunny Naqi – Fixed Income Analyst
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