Earlier this week, JPM's head quant Marko Kolanovic did a "sort of" mea culpa when he admitted that his note from last week, in which he projected that there would be no systematic selling, was not exactly "correct" in light of what would end up being the "biggest VIX buy order in history" as VIX ETPs were crushed in a terminal short squeeze, that sent the VIX soaring by the most on record. However, in what has become a bizarre transformation, Kolanovic who until recently endorsed a prudent and cautious approach to investing, urged investors to once again "BTFD", going so far as suggesting that central banks would step in to halt any potential rout. Judging by Bill Dudley's just concluded comments amid today's plunge in stocks, that does not appear to be the case, at least not for a while.
Fast forward to today, when Kolanovic has released an unprecedented third note in one week. In today's edition he takes a step back, to more objectively examine the sources of the rising VIX wave, saying that the current crisis has played out exactly the same as the August 2015 crisis.
But first, now that the "current crisis" is panning out much more seriously than Kolanovic first expected, here is how the JPM quant frames the current situation:
In our note on Monday we argued that the current selloff is entirely technical in nature, that fundamentals did not change, and as such that we believe that it is an opportunity for human investors with some tolerance for market volatility to step in (the market is up ~1% since). In our previous research we highlighted how liquidity shocks may develop and argued that the collision of selling from various systematic strategies and diminished equity liquidity provided by electronic market making in times of stress will produce liquidity crises. In particular, strategies that are selling are those that use realized volatility, correlations, VIX and price momentum as signals to adjust exposure, and AUM in these strategies increased greatly over the past decade. On the other side, electronic market making depth becomes severely diminished at the same time these signals are triggered. In our previous research, we also mapped out how some popular exchange traded volatility trading products will collapse. Finally, we outlined in our 2018 outlook that low VIX levels are not a new normal, and that volatility and tail risks will rise in 2018.
With that said, Kolanovic repeats what we said last week, namely that those who were around 2 and a half years ago should be filled with a sense of deja vu, because what is going on this week in equity markets is a carbon copy of the ETFlash Smash of August 2015, where first the ETNs, then CTAs then Risk Parities all blew up sequentially, crushing market liquidity, only because it took place in the premarket everyone blew up at exactly the same time, and the sequence of events was drastically truncated. Here is Kolanovic:
From the aspect of systematic flow and electronic liquidity, the current crisis has played exactly the same as the Aug 2015 crisis. It started with the de-risking of trend followers, short volatility positions, and strategies sensitive to bond-equity correlation. Similar to Aug 24th, by far the largest and quickest punch came from hedging flows for the trillion dollar+ S&P 500 index put option complex (gamma hedging) on Monday, and was compounded this time with liquidations in the VIX complex. As this was unfolding, electronic liquidity, in the once most liquid product, S&P 500 e-mini futures, evaporated.
As measured by market depth in futures, liquidity on 2/6 dropped by ~90% (compared to the first few weeks of the year). Once volatility was out of the bottle (~5% move on Monday), various forms of volatility targeting strategies (with AUM in excess of $300bn) were set in motion and added outflows that will keep investors on edge for several days.
In an amusing aside, Kolanovic says that "we think some of these systematic strategies may end up selling at the lows (and later on buying it back at the highs)." Not to mention retail investors, of course, all of whom XIV at the highs, relatively speaking, and were wiped out overnight on Monday.
And yet, just as we noted this morning, there is one notable difference from 2015: so far the vol crisis has been contained exclusively to equities, or as the JPM analysts says:
"while for equities this looks like a 2015 type of crisis, other asset classes disagree. This is because there is a big macro/fundamental difference between now and the Aug 2015 market crisis. In 2015, we dealt with an EM crisis (e.g. China), crisis of credit spreads, collapse in commodity prices, and weak global growth. There were legitimate fears of a global recession. Now, the situation is exactly the opposite: global growth is very strong, US corporate earnings are at record highs (and continue to be revised higher), commodities have stabilized, and the USD is weak."
Ah yes, but the "common narrative" is one in which inflation - not deflation - can unleash the next economic crisis, by way of the market as the signal carrier, with risk assets crashing and unleashing the next economic contraction. Frankly, it is surprising that Kolanovic won't even acknowledge this. After all, one look at the market, and it is beyond obvious that stocks selloff every time the 10Y approaches 2.85%, a level that has become a true 'red line' for equities. In fact, one can argue that in 2015, the risk of a global economic crisis was positive for stocks, as it meant more NIRP, and more QE if things got out of control: the only two catalyst that have moved stocks higher for the past decade. This time around, everything is flipped, with inflation the latent bogeyman.
Touching on none of this, Kolanovic instead makes an emotional appeal to fundamental investors, again: please BTFD:
We also want to add that the new Fed chair, vetted by the current administration that uses the stock market as a score card, is highly unlikely to do anything to derail markets and the economic cycle. All of these factors make a big difference, and should give confidence to fundamental investors to step in and short-circuit the feedback loop of programmatic selling and depleted equity liquidity. In an odd way, the market correction that happened early in the year (still low rates, strong global growth, tax reform earnings boost) may further extend this bull market cycle. Valuations have normalized (and are now close to historical averages), pockets of extreme leverage are defused (e.g. selling volatility, large speculative longs, etc.), and central banks will likely be a lot more cautious going forward given the market fragility lesson of this week (e.g. see Kuroda’s recent statements).
Here, Kolanovic makes a modest concession, and touches on the recent spike in yields, saying that it should be far less of an issue than it was when the 10Y was "well above 3%": "Regarding the concerns of rising interest rates, we note that in the 2010-2013 time period we often had 10 year yields well above 3% in an environment of weaker growth."
Ah yes, but global debt has also risen by about $60 trillion since 2010, which obviously means that interest rate breakevens are far lower especially in a world in which the neutral rate or so-called r-star is around 0%.
Kolanovic concludes by making a point that propagated across the financial media on Tuesday, namely that aside from equities, vol in other assets has barely budged.
This stark difference from 2015 is obvious when looking at volatility across asset classes. Through the lens of the VIX, this may look as bad as or even worse than 2015, but through the lens of interest rate volatility, credit spreads and FX volatility, current events look like the smallest of 5 crises since 2015. We do note that equity volatility will not go down back to the lows near-term (e.g. VIX of 10), but we expect it to decline from current levels, and for the term structure to normalize relatively quickly.
While that may have been the case a few days ago, as of this morning it no longer is: as we wrote earlier in"Will The Market Shock Escalate Further: It Depends On Just This One Thing", the reason why equities are tumbling again for the second time this week, is that slowly but surely vol everywhere else, and especially in rates, is starting to tick up, catching up quickly with stocks.
The question is where and when does it stop, and will all those who are being invoked to enter the pool because the "fundamental" water is warm, be convinced that the vol contagion from equities to other asset classes, be halted, or if it will continue to spread with every passing day.
Finally, to all those wondering if they should follow the advice of Kolanovic, who incidentally failed to correctly anticipate Monday's VIX eruption even with the benefit of observing Friday's post-payrolls meltdown, recall our post from yesterday in which we quoted the SocGen analyst who did predict Volmageddon - his words: "Don't even think about buying the dip."