In the latest Sunday start from Morgan Stanley, the bank's co-head of economics, Elga Bartsch looks at - what else - the eerie, record calm gripping capital markets despite the daily bombardment, so to speak, of deteriorating geopolitical news, US and European political upheaval, deteriorating economic data, and confusion about China's credit impulse. And while her advice is not to get too concerned about the future, telling clients "you probably should book your summer holidays if you haven't already", the investment bank is quietly joining the ranks of Goldman and JPM in warning that the record low vol won't last, and is likely to see a rebound just around June, or when the summer holidays begin in earnest, with the most likely catalyst being "surprises" around central bank announcements.
As a result, she proposes a "barbell" pair trade, one for each potential outcome: a blow off top in the market, or a "risk flaring" swoon in stocks, which will come to credit markets first:
- On one hand, buy S&P calls as "options are only pricing an 8% probability of the 15% S&P rally that our Chief US Equity Strategist Mike Wilson forecasts in his base case"
- On the other, buy CDX HY puts: "contrary to just buying vol itself, such a differentiated approach allows us to express our conviction that, in a late-cycle US economy, a broad deterioration in credit markets will likely precede any equity market downturn. "
Her full note is below:
The Lure of a Summer Lull
Have you booked your summer holidays yet? If not, you probably should. Whether you are going back to your favourite vacation spot or trying a new location, you will wonder whether markets are going to allow for a quiet summer. Record-low readings of the VIX suggest that investors have little to worry about at the moment. In our view, the current low level of volatility seems unsustainable though, but the exact timing of a volatility rebound remains uncertain.
Given that we have been here before – when the euro crisis escalated in 2012, when bond markets threw a taper tantrum in 2013 or when the PBOC rejigged the RMB regime in 2015 – let’s assess the risk of more turbulent markets this summer. For now, equity markets are reassured by a strong earnings season on both sides of the Atlantic. Furthermore, central banks are seen to proceed cautiously and communicate clearly. In the case of the Fed this means tightening policy gradually. In the case of the ECB it refers to maintaining an expansionary stance.
Heading into the summer, a number of events could push market volatility higher. For starters, both the Fed and the ECB could surprise markets at their June meetings. With respect to interest rates, a Fed hike and an ECB hold are as good as certain. But unexpected shifts in forward guidance, especially on balance sheet policies, are a risk. A shrinking Fed balance sheet means weaker market technicals and smaller shock absorbers. Our US fixed income strategists highlight that both MBS and US Treasuries will see a sizeable swing in new issuance into positive territory next year.
A set of international factors ranging from a further material decline in oil and commodity prices, an unexpected surge of protectionist policy measures, a sharp escalation of geopolitical tensions or concerns about policy over-tightening in China could reduce global risk appetite. Equally, if US growth failed to gain momentum in 2Q, this would likely rattle markets. A plunge in our real-time big-data activity indicator in the US, ARIA, hints at a possible softening in 2Q GDP tracking estimates. Such softening could challenge the conjecture that the gap between soft surveys and hard data will be closed by the subdued hard data converging to elevated sentiment levels.
Against this backdrop, and with less liquid market conditions over the summer in mind, our cross-asset strategists looked at the implications of the VIX temporarily falling below 10. In their latest Cross-Asset Brief, they argue that while VIX at such historically low levels was in sync with other risk and volatility metrics, such low vol is unlikely to be sustained. Looking at the historical market performance, they found that equities usually do okay in the wake of such low VIX readings and often only experience modest declines. In the past, such low-volatility periods have persisted for at least 2-3 months. In many countries, a 2-3-month period would only stretch to the start of the summer school holidays though.
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Hence, it might make sense to put on trades that hedge against unexpected market moves over the summer. To do so, Phanikiran Naraparaju suggests taking advantage of the low implied vol by buying both tails of the distribution of possible future market dynamics. Specifically, he would buy S&P 500 calls to position for the right tail event of a further late-cycle risk rally. Currently, options are only pricing an 8% probability of the 15% S&P rally that our Chief US Equity Strategist Mike Wilson forecasts in his base case. To hedge against the left tail event of an unexpected downturn over the summer, he would buy CDX HY puts. Contrary to just buying vol itself, such a differentiated approach allows us to express our conviction that, in a late-cycle US economy, a broad deterioration in credit markets will likely precede any equity market downturn.
Once you have put on your trades for the summer, don’t forget to book your summer holidays as well! After all, the anticipation of a week on the beach, by a lake or in the mountains is half the fun