Kolanovic: "Clients Are Asking If This Selloff Will Make The Quants Puke"

Having maintained radiosilence for much of 2018, on Thursday afternoon JPM's top quant reemerged, and pointed out that "many clients are asking if the recent risk-off move was significant enough to drive broader de-risking of such 'delayed response" systematic investors as CTAs, Volatility Targeting and others."

And while the two-day selloff at the start of the week was indeed unexpected, and quite violent, resulting in numerous sharp position reversals as Nomura's Charlie McElligott wrote on Tuesday, Kolanovic is far more sanguine, and writes that the recent market sell-off and spike in volatility was not large enough to trigger broad deleveraging among systematic investors, as the following excerpt reveals:

Consistent with our previous research, we think that the move was not large enough to trigger broad deleveraging. Equity price momentum is positive and trend followers are not likely to reduce equity exposure. While the recent move was concerning for its correlation properties (bonds, equities and commodities all going lower), overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small (e.g., increased from —4% to —5%).

He also notes that while the sharp 2-day move was concerning for its correlation properties, overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small.

"That we are in the midst of one of the strongest earnings seasons in the US, and global growth continues to be strong" also does not favor a continued sell off Kolanovic says.

Amusingly, after we quoted Kolanovic earlier this week  saying that 2.75% in the 10Y is critical...

 "should bond yields continue increasing (e.g. 10Y beyond 2.75%) this will risk an equity sell-off that usually triggers a broader deleveraging of var-based strategies."

... he is backing off from this assessment, now that the 10Y is above it:

A common question is at which level bond yields become an issue for equity multiples. While we quoted 2.75% a few years ago, this was at a time when global growth was significantly weaker than it is now (EM crisis, US earnings recession). We believe one should not look at a specific level of bond yields in isolation from the level of economic activity and positive catalysts such as fiscal easing. We think that the current level of rates do not yet pose a major risk for equity multiples.

Almost as if Gandalf was given the tap on the shoulder...

Finally, if JPM's clients shouldn't be nervous now, then when? To that, the JPMorgan quant "wizard" has this response: maybe in a a few weeks.

"In terms of timing market downside risk, we would be more concerned about the period after the Q1 earnings season, when fiscal reforms are likely to be priced in and central banks make further progress on the normalization of monetary policy."

His full observations below:

After a few days of market sell-off and an increase in market volatility, many clients are asking if the move is significant enough to drive broader de-risking of systematic investors such as CTAs, Volatility Targeting and others. Consistent with our previous research, we think that the move was not large enough to trigger broad deleveraging. Equity price momentum is positive and trend followers are not likely to reduce equity exposure. While the recent move was concerning for its correlation properties (bonds, equities and commodities all going lower), overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small (e.g., increased from ~4% to ~5%). Also, there are other circumstances that are not in favor of a continued sell-off – we are in the midst of one of the strongest earnings seasons in the US, and global growth continues to be strong.

We also want to comment on two other issues: bond yields and tax reform. A common question is at which level bond yields become an issue for equity multiples. While we quoted 2.75% a few years ago, this was at a time when global growth was significantly weaker than it is now (EM crisis, US earnings recession). We believe one should not look at a specific level of bond yields in isolation from the level of economic activity and positive catalysts such as fiscal easing. We think that the current level of rates do not yet pose a major risk for equity multiples.

Finally, there is the question to what extent fiscal reform is priced into the market. We are of the view that tax reform is only partially priced into the equity market. We attribute the bulk of the recent market appreciation to the uptick in global growth, and weaker USD. Talking to our clients, we still find risk aversion and hesitance about the impact of fiscal reforms and political developments (e.g., mid-term elections, Nunes memo, etc.). The fact that small caps, tax beneficiaries, value and domestic stocks are lagging since the bill (e.g., vs. international, growth, large-cap tech) is evidence that fiscal reforms are not fully priced in. In terms of timing market downside risk, we would be more concerned about the period after the Q1 earnings season (e.g., in ‘sell in May’), when fiscal reforms are likely to be priced in and central banks make further progress on the normalization of monetary policy.