In­vestors pon­der fur­ther shocks af­ter N Korea jolt

Kuwait Times - - BUSINESS -

Af­ter this week’s war of words be­tween the United States and North Korea trig­gered the big­gest fall in global stocks since the US pres­i­den­tial elec­tion, in­vestors are won­der­ing what other of­fradar shocks may be wait­ing to rock world mar­kets. Al­though there is lit­tle sign so far that in­vestors are pro­tect­ing them­selves against a major sell-off, some say the cur­rent en­vi­ron­ment masks la­tent risks.

“Ev­ery day, our risk mod­els tell us to take more risk be­cause of fall­ing volatil­ity but with mar­kets be­ing where they are, we have to be very care­ful in not fol­low­ing them blindly,” said James Kwok, head of currency man­age­ment at Amundi in London. “So we try to project sce­nar­ios on what can go wrong and where are mar­kets not look­ing.” Such has been the ex­tra­or­di­nary pe­riod of sta­bil­ity in fi­nan­cial mar­kets in re­cent years that world stocks have hit a se­ries of record highs while gauges of broad mar­ket volatil­ity have plunged to record lows.

That be­nign in­vest­ment en­vi­ron­ment has been fos­tered by cen­tral banks which have pumped vast sums of cash into economies since the global fi­nan­cial cri­sis that be­gan a decade ago, lift­ing as­set prices glob­ally. Flows into most as­set classes have al­ready over­taken peaks reached be­fore the fi­nan­cial cri­sis.

For ex­am­ple, in­flows into ac­tive and pas­sive eq­uity funds have nearly dou­bled to $10.9 tril­lion at the end of June 2017 from a Septem­ber 2007 peak, ac­cord­ing to Thom­son Reuters Lip­per data. In­flows into bonds have mean­while in­creased nearly three-fold to $4.1 tril­lion in that pe­riod.

Broad mar­ket gauges of risk, such as the CBOE Volatil­ity In­dex, bet­ter known as the VIX, and its bond mar­ket coun­ter­part, the Mer­rill Lynch Op­tion volatil­ity in­dex re­main pinned near record lows de­spite a spike this week.

But an­a­lysts say low mar­ket volatil­ity masks the heavy weight of op­tions writ­ten on th­ese gauges by in­vest­ment banks bet­ting that the calm con­di­tions will per­sist for a long time.

That has been ac­com­pa­nied by the grow­ing pop­u­lar­ity of in­verse-volatil­ity ETF prod­ucts, which have dou­bled in value this year as mar­ket volatil­ity has cratered. Mor­gan Stan­ley strate­gists say the vol­ume of bets on volatil­ity re­main­ing low means even a small in­crease in price swings could force some of th­ese lever­aged bets to un­wind, trig­ger­ing shock waves in the fi­nan­cial sys­tem and send­ing stock mar­kets tum­bling.

Daily per­cent­age changes are im­por­tant in the volatil­ity world be­cause a lot of th­ese ex­change-listed prod­ucts and notes are re­bal­anced daily based on th­ese changes, so that any large change would au­to­mat­i­cally trig­ger selling pres­sure else­where.

“This is why lower volatil­ity cre­ates higher risk,” said Christo­pher Metli, a Mor­gan Stan­ley quan­ti­ta­tive de­riv­a­tives strate­gist in a re­cent note. He es­ti­mates that a 12 point rise in the VIX could send the S&P 500 in­dex down by 3.5 per­cent. A move of that mag­ni­tude was last seen af­ter Bri­tain’s shock Brexit vote in June 2016.

But a spike in volatil­ity is not the only sce­nario wor­ry­ing in­vestors. Other risks mar­kets may be ig­nor­ing in­clude the im­pli­ca­tions of a messy Bri­tish exit from the Euro­pean Union and the risks that the Qatar cri­sis could spiral out of con­trol in the Mid­dle East and hit oil prices. Even the prospect of a new­comer at top of the U.S. Fed­eral Re­serve when Janet Yellen steps down in 2018 could prove un­nerv­ing.

low volatil­ity

“Today’s low volatil­ity is the calm be­fore the storm and doesn’t re­flect the real world in which com­pa­nies are op­er­at­ing, or the major un­cer­tain­ties that are de­vel­op­ing,” said Paul Hodges, chair­man at In­ter­na­tional eChem, a con­sul­tancy.

An­other vari­able is the ex­pec­ta­tion that cen­tral banks will soon start un­wind­ing their mas­sive post-cri­sis stim­u­lus mea­sures, with un­pre­dictable re­sults. One of the big­gest risks seen lurk­ing is the rise and grow­ing in­flu­ence on the world’s stock mar­kets of pas­sive funds, which aim to track rather than beat bench­marks and charge lower fees than their more ac­tively-man­aged peers.

The pro­por­tion of stocks on the main US bench­mark eq­uity in­dex that are now owned by such pas­sive in­vestors has nearly dou­bled since the 2008 cri­sis to 37 per­cent. But re­demp­tion pres­sures on large pas­sive in­vestors could ex­ac­er­bate any mar­ket sell­off. Ap­ple Inc, a stock mar­ket dar­ling, has a fifth of its out­stand­ing stock held by in­dex funds with Van­guard, Black­Rock and State Street mak­ing up the top three hold­ers, ac­cord­ing to lat­est Thom­son Reuters data.

The head of sales of a large Bri­tish­based bond fund said some of its clients are try­ing to put to­gether pools of money with which to snap up beaten-down stocks if a large emerg­ing mar­ket­fo­cused ETF is faced with sud­den re­demp­tion pres­sures.

“We get a lot of queries on what are some of the risks that mar­kets may be over­look­ing, and that is what keeps us up at night,” he said. — Reuters

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