Goldman: 2019 - Lower Liquidity, Higher Vol, More Fragile

In June 2018, Doug Cifu, co-founder and CEO of Virtu Financial, bragged to Goldman Sachs about the liquidity, efficiency, and transparency that the new market structure delivered to market participants...

"If you’re a buy-side institutional investor comparing your liquidity to, say, 15 years ago, you need to consider not only how much liquidity you were getting back then, but also what spreads you were paying and the information you were giving up.”

Since then, markets have tumbled and with them, liquidity has utterly collapsed recently  ...

...and unfortunately, in a perverse feedback loop, the more equities drop, the worse the overall S&P liquidity, as the following chart from Barclays show, depicting the collapsing bid/ask size in the Emini, which is now do to the lowest on record.

So six-months after Cifu's comments, Goldman asks - Where we stand now:

  • Volatility rose again and stayed elevated. A period of low volatility post the technically driven spike in February—when the VIX reached 50—ended in October, as waning growth expectations helped trigger an equity market sell-off. Despite a roughly 14% decline in the S&P 500 since its September 20 peak, the VIX did not top 30. However, equity market volatility has remained elevated, potentially signaling a more sustained period of higher volatility.

  • Inverse VIX ETPs - one of the primary drivers of the February VIX spike - remain diminished. Indeed, these products now make up less than a quarter of all VIX ETPs (versus more than 50% in December 2017). That means a re-run of the ETPdriven February VIX event remains unlikely, at least in the near term. However, growth in investments that demand nearinstantaneous liquidity still runs the risk of occasional liquidity mismatches—and the corresponding market impact.

  • Increased vol of vol has remained a key feature of 2018, especially in the US. In other words, multiple asset classes have endured faster and larger price swings relative to history right after periods of relative calm. Examples include the February/October equity market drawdowns; the Italian government bond sell-off in June; and oil’s price swings this fall. In another notable trend—and a break with past norms—European equity markets have been less volatile than their US counterparts in 2018.

  • Deteriorating liquidity conditions appear to be a key driver of higher volatility. Top-of-book depth—a measure of market liquidity—has been declining: the average bid/ask depth for E-mini S&P 500 futures in 2018 was lower than in any year since 2011, and has ticked down further since we published in June. This trend is meaningful, as realized volatility tends to rise when market depth falls. Indeed, top-of-book depth has outperformed recent realized volatility, recent implied volatility, and volumes in predicting realized volatility.

  • Technical factors and market structure may also be contributing to erratic price action. These include pro-cyclical investment strategies, such as Commodity Trading Advisors (CTAs), vol targeting, and risk parity; levered or liquidity-constrained exchange-traded products; high frequency traders (HFTs); and gamma effects from extreme options positioning, such as WTI oil puts in October or S&P 500 calls in February.

And more importantly, what to look for in 2019 (and beyond):

  • Elevated volatility... Our forecasts for economic growth imply a baseline level of S&P 500 monthly realized volatility of 13.4 in 2019; liquidity metrics alone point to a higher level of 19.1. We expect volatility in this range early next year, with the positioning of professional investors as a key indicator of whether volatility will be closer to the lower or the higher end.

  • ...but fundamental support remains. Despite slowing global macro growth and deteriorating liquidity, a 2019 recession still looks unlikely. Similarly, a significant acceleration in US corporate earnings seems unlikely to us. We believe this makes extreme one-year outcomes less likely than the SPX options market is pricing (+/- 16% total return).

  • Potential for liquidity-driven dislocations. We believe low liquidity raises the risk of short-term market dislocations without significantly impacting assets’ long-term fundamental value. Therefore, our equity derivatives research team likes owning direct forms of short-term volatility (e.g., forward starting variance, VIX) and selling fixed-strike strangles to position for a range-bound market over the longer term.

  • Risks that “liquidity is the new leverage.” We have cautioned that low market liquidity may prove to be an important and underappreciated risk, analogous to excess leverage in the last cycle. For example, evidence suggests that in periods of stress (particularly around macro catalysts) HFTs may withdraw liquidity more aggressively than human traders, causing liquidity to dry up when it is needed most. Top of Mind interviewees have also cited increasing equity market fragmentation—as well as the regulation helping to drive it—as a factor contributing to market stress; this will be key to watch in the years ahead.

  • Positive returns for risk assets, but with reasons to hedge. We think above-trend economic growth still points to positive risk asset returns over the medium term. But given increasing tail risks and the liquidity/volatility concerns discussed here, we recommend hedges such as gold and the Japanese yen, as well as an overweight in cash in our asset allocation.

  • A preference for quality. In addition to hedges, we recommend investors position for a more volatile, late-cycle environment by shifting up in quality. In the equity and corporate credit space, that means seeking out companies with solid balance sheets and pricing power, which should help protect against cyclical headwinds.

So less liquidity, more volatility, and the looming teeth of fragility increasingly present...and right on schedule, VIX is starting to track the Treasury yield curve to higher volatility.