Charting This Year's Cross Asset Chaos
Whether it has been investor sentiment, equity implied volatility, or sovereign bond spreads, 2011 has been a year of extremes. The roller-coaster of various spreads, prices, curves, and flows still leaves us cognitively dissonant as we anchor on recent action and forget where we came from. BofA has produced a 'stress heatmap' that at-a-glance illustrates the behavior of 20 critical cross asset class warning signals throughout 2012 and we note this Critical Stress Signal has been in risk-off mode since July 12th - which fits well with the relative perspective we have long-held that high-yield credit is pricing for considerably more concerns than equities for instance. Seven crucial aspects are highlighted throughout the year, most notably the slower than expected tail-risk hedge demands in Europe as we suspect ECB QE complacency remains far too high. Nowhere is that optimism more evident of policy maker intervention than in the money flow indicators currently.
From BofA 2012 Global Asset Allocator
Seven crucial periods stand out in the stress heatmap:
1. Equity implied volatility continued its past behavior of underpricing risks flagged by other asset classes until the last moment, resulting in large shocks when risky assets sold off
2. Investor sentiment as indicated by Flow components were “risk-on” for most of the year, even as most market based stress measures were stretched. After a period of ‘risk-off’ in the middle of the year, the Flow-based measures are back in non-stressed territory, suggesting relatively neutral positioning into year-end
3. There were pockets of value to be found in hedges through the year: such as Equity Implied Volatility ahead of the Aug sell-off and FX Implied Volatility in late August
4. Bank funding concerns (Cross currency basis swaps) remained high through the year
5. Global Sovereign Credit stress increased significantly in Q3; it remains at historical highs
6. Some European Government bonds started losing their safe-haven status in late October
7. Demand for tail hedging was high through most of the year. Surprisingly, European tail-hedging demand was slightly lower than in both the US and Japan (ESTX50, S&P500 and Nikkei Skew).
The BofA Global Financial Stress Indicator's (GFSI’s) Critical Stress Signal has been in ‘risk-off’ mode since 12-Jul. Since then global equities have dropped 10%, commodities by 6%, and HY bonds 3%.
While BofA continue to recommend caution for investors looking to add risk, they acknowledge that policy intervention risk can lead to rapid risky-asset upside (and we did notice that the investor flows - lower right hand corner of the upper chart - as captured by the GFSI appear to be anticipating this risk)
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