On Friday, when we described the assessment of UBS derivative strategist Rebecca Cheong, who anticipates as much as $150 billion in program and systematic strategy selling in the next 2-3 days, we wondered if the Friday silence from JPM's quant guru meant he was willing to hand over the baton of the market's most prominent prognosticator of quant moves to others. The answer was no, because shortly thereafter Kolanovic chimed in with a note just after the US close, in which he agreed with Cheong and said that the program selling was about to begin, to wit:
As we noted earlier this week, we expected a Brexit outcome to have an asymmetric impact for equities, with downside exacerbated by unwind of long equity investor positioning. In particular, increasing equity volatility would induce systematic strategies (Volatility Targeting, Risk Parity, CTAs) to start deleveraging their high equity exposure, resulting in $100-300 billion of selling.
The reason is simple: few were prepared for a Brexit outcome and "going into this event, long/short equity and macro hedge funds had higher equity exposure than average, while mutual fund cash balances have remained low and retail investor equity exposure were close to 2007 highs."
Kolanovic adds that "this comes at a time of a weak fundamental backdrop, where corporate earnings are expected to contract for a fourth consecutive quarter (3Q15 to 2Q16E)."
Specifically, regarding the impact of Brexit on fundamentals, Kolanovic believes it will be contained: "Direct impact of Brexit to US corporate profitability will likely be contained, with S&P 500 revenue exposure at ~1% to UK and 6-7% to Europe."
That's the good news. Here's the not so good:
The bigger unknowns, however, are the second order effects, which could manifest themselves through various potential channels. Geopolitical uncertainty around trade and regulatory framework is a risk as it could spill over into business sentiment. Financial contagion could materialize if the banking sector continues to see significant weakness and spread into Eurozone periphery, even though leverage in the system may not be high. In any case, higher volatility from these uncertainties may in itself be enough to induce investors to deleverage and reduce their high equity exposure. While these risks are potential catalysts for a market correction in the short term, it is reasonable to expect these would not precipitate a global recession as central banks globally are expected to intervene and provide liquidity and staunch contagion from spreading. In fact, the Fed noted this morning that it is prepared to offer dollar liquidity through existing swap lines, and the market is expecting a significantly more dovish US rate outlook with no hikes priced in for two years.
Finally, his conclusion: "We see another 5-10% downside to the S&P 500 in the short term as likely, but we maintain our 2016 year-end price target at 2,000."