It is certainly no secret that we live in volatile times. It is also no secret that the global economy is as far from equilibrium as it has ever been courtesy of historic direct monetary infusions from global central banks, which keeps world markets propped up at levels that according to some, are between 75% and 150% higher than fair values. What has recently become obvious is that nobody dares to take on the central banks, and specifically the Fed, as there is now a wholescale effort to destroy all bearish mindsets, whether it is by perpetuating the blatantly illegal HFT infested upward-bias broken market structure, encouraging custodian house wholesale short squeezes, or outright fraud, such as the recently disclosed illegal cash transfers to mortgage servicers, and fake fundamental data disclosure of such accounting monsters as Repo 105, and FASB mark-to-market redundancies. Should all these measures to keep the market rangebound, and hopefully cause an even greater short squeeze, fail, we have little doubt that selling of any assets, together with non-naked shorting, may soon be deemed illegal in the current system's last ditch attempt to keep the broken ponzi regime working. Yet what is certain, is that all of these measure will sooner or later fail. Which means that the most industrious investors are currently looking for ultra cheap ABX-like insurance trades, which have little cost of carry, and which promise Pellegrini-like returns when one or all elements of the Ponzi once again begin collapsing. To that end, we present the most recent "cheap insurance" ideas from SocGen's Dylan Grice, who has compiled what may be the cheaper ways to bet against the central banks in such items as inflation, deflation, bond market blow-ups and instability in the oil market. Here are the suggested trades.
Here is how Dylan prefaces his insurance proposition:
Albert [Edwards] and I have a reputation as bears. And it’s true that we tend to focus on the downside. But that’s because we believe that over the long haul, those who think about risk scenarios - whether precedented or not – are more likely to be prepared for them and to know a good hedge when they see one. So this week I want to explore some insurance ideas around inflation, deflation, bond market blow-ups and oil market instability. If we can manage our downside risks well, the upside will look after itself.
“Hope for the best, prepare for the worst,” goes the adage. It would be nice to think that the crash and near collapse of 2008 was anomalous, unusual and unlikely to be repeated. But a cursory glance at any history book shows how regular such ‘outliers’ are. We wish it weren’t true, but the fact is that bad things happen. Regular readers know Albert and I spend a lot of time thinking about downside risks. We don’t do this because we think we can predict when they’ll happen or even if they’ll happen. We do it because they might happen and the most basic defence against the ‘sea of troubles’ is to be aware of just how outrageous the slings and arrows of fortune can be.
And the following thought can be shared by all those who, for some odd reason, are seen by the broader Koolaid sipping lemmingated crowd (which no doubt was screaming bloody murder in November 2008 and March 2009), as Perma bears:
We have no qualms about being thought of as extreme bears … but the truth is that being realistic isn’t the same as being pessimistic and we’d bet on the prepared realists over the blind optimists every time. If readiness is the first blockade against the unexpected, well chosen insurance is the electric fence. So this week I want to focus on some insurance ideas.
As pointed out previously, prevailing volatility levels are notably higher than during the credit bubble period. This in itself argues that cheap insurance will likely not be very easy to come by.
Luckily, not easy does not mean impossible.
The first core problem facing the world economy, as postulated by the vast majority of market participants, is deflation. Cue Grice:
So what kind of insurance is available? The following chart shows 0% 5y inflation floors for the US and Eurozone. They are priced at 360bps and 220bps respectively. That means that someone fearing US deflation could, by making an upfront payment of 360bps, secure five annual payments of any end year YoY inflation rate below 0%. (Very) roughly speaking, the buyer makes money if deflation averages a rate lower than -360/5 =-0.7% per year for the next five years. Notwithstanding my bias that the long-term tail risk is inflation rather than deflation, there is undeniable deflation risk in the next few years (see below). But that looks incredibly pessimistic to me. In fact, I thought it looked too good to be true and that it couldn’t be a real price. But I only came across the idea during a trip to Scandinavia a few weeks ago when one of our salesmen was looking for a seller of the European CPI floors … (willing sellers make yourself known and I’ll put you in touch with him).
It is not surprising that with the prevalent mindset being on deflation as the primary risk, such deflation insurance is rather expensive. So maybe looking half way around the world will present some better opportunities. To Grice, that may just be the case: "In my opinion, the biggest deflation risk is of a hard landing in China. Without going into too much detail, some of the bubble-warning lights are flashing – the explosive credit growth (which Taylor and Schularick have identified as the best predictor of future financial crises), the soaring land prices (nearly 80% annualized in parts of the country with price-to-rent ratios of 30 times, according to Wu et al from the NBER), and the increasing ‘this time is different’ feel."
So how does one isolate the Cheap insurance on a China crash?
According to this armchair psychologist theory, the ‘equilibrium’ level of volatility will be a constant and the best guess of this unobservable constant will be market volatility recorded over as long a period as possible. So the answer to the original question “is equity insurance expensive because it’s higher than it was before the 2008 crash?” is “not necessarily.” But the annualized volatility of the S&P going back to 1964 is around 16% (its 14.3% going back to 1881!) suggesting the current 6M implied volatility of about 23% is rich. A similar picture is true in Japan and in Europe. So while it’s reasonably certain that in a Chinese hard landing scenario, world equity markets would take a bath, the downside protection is too expensive. However, that doesn’t mean all downside protection is expensive. Hang Seng volatility since 1964 is 28.5%, while the 6M implied volatility is only 21%. And given Hong Kong’s cleaner exposure to China, this looks like a better place to look for downside insurance.
We certainly agree with Grice, that while deflation/deleveraging is currently raging, it will be merely a temporary phenomenon. Sooner or later, the deranged Fed will do something so idiotic to spark not outright inflation, but loss in the entire current monetary system, sometimes called hyperinflation.
One place where one can find cheap insurance to monetary instability on the upside may be in Silver ATM Implied Vol versus Realized Vol:
Another place might be in the commodity markets. Silver is thought of as ‘poor man’s gold’ and it certainly has some of gold’s monetary attributes. Fundamentally though, it’s an industrial metal, its price being largely swung around by the industrial cycle. The following chart shows current implied volatilities for three-month options to be marginally lower than the average realized volatility since 1970 of 35.5%. The chart also shows the 3M 25d put priced with an IV of 30.9.
Which brings us to the most prevalent and underappreciated risk: the credit bubble implosion. Is there a cheap way to hedge for that one moment when the Fed loses control of the world's biggest market? It appears there may be.
One of the recurring themes on these pages over the last year has been that our governments are insolvent. This strongly implies a longer term inflation – not deflation – risk. However, long before we arrive at an inflationary outcome where central banks are persistently monetizing government deficits, we’d see bond market distress of a type we’ve recently glimpsed in Europe. Unfortunately, we don’t know when that’s going to happen because we have no way of knowing when the market loses confidence in a government’s ability to fund itself.
In Japan’s case we don’t know when the retirees drawing down their assets will affect the government’s funding ability; in the US we don’t know whether or when the Chinese will lose their appetite for US bonds (though some FX observers watching the Japanese struggle to contain the yen’s advance are arguing they already have); in Europe we don’t know if the EFSM aimed at bailing out the peripheral economies will be robust in a renewed market panic. All we do know is that it has the makings of an ugly situation and that if we can protect ourselves against it at the right price we should.
The following charts show some of the swaptions market IVs compared to historic volatilities for US and Japanese rates and on this basis both look cheap. However, for the real blow-up scenarios we’d want to go further out of the money and look at payouts for particular interest rate scenarios. Our derivatives guys tell me that in Japan, for example, there are attractive multiples available with payouts of seven/eight times invested premium on offer for scenarios where 10y yields go beyond 4%, but that’s outside the scope of this week’s note. Suffice to say that if the basic IVs look attractive, the more out-of-the-money options might too.
And lastly, with the biggest daily geopolitical risk factor being obviously the festivities coming out of the middle east, the last asset class that is in dire need of cheap insurance is oil. Grice summarizes this risk factor as follows:
there is a possibility the Israelis will eventually attempt to thwart Iran’s nuclear ambitions, as they acted against Iraq in 1981 and against Syria in 2008. Since most intelligence reports suggest Iran is now six to 12 months away from having nuclear warheads (which may or may not be accurate, but Israeli hawks will argue that it has to be treated as though it is), there is a window in which to strike, and that window is now.
All of these seem like attractive entry positions into cheap insurance plays, which will pay off in droves should the black (or gold, or oil, or China) swan strike. In some ways holding a basket of all these trades should make one immune to fat-tail risk. We will continue looking for comparable cheap insurance plays and presenting these, as the moment of unwind of the current fake (dis)equilibrium is certainly getting closer with each passing day.