A surge in trade war talk and a brief tariff tantrum has done nothing to slow the roll of the market’s most-leveraged longs.
In fact, as VIX ignored the rise of Trump’s trade war that the world and their pet rabbit believes will crash the global economy and bring fire and brimstone from the earth, VIX futures traders have piled back into their shorts…
With hedge funds (leveraged investors) now back at their most short VIX since Dec 2017…
But, while the ‘complacent’ vol-sellers are back en masse at the index level, trade war anxiety among individual stock traders is running high…
As Bloomberg reports, it’s showing up in indicators that plot bearish and bullish options, in a lingering preference for defensive industries and the refusal of hedge funds to commit new money.
With stocks nudging unerringly higher, options traders worry they’ll fall. The Cboe put-to-call ratio for equities, tracking volume in bearish versus bullish bets, averaged 0.6 in the 10 days through Wednesday, the highest since early May.
And the ProShares Ultra VIX Short-Term Futures ETF, which rises when volatility goes up, has seen dramatic inflows in the last two weeks (even as the price has fallen).
Additionally, Bloomberg points out that most of the nervousness is being felt in individual stocks and enough industries are doing well that the effect is masked when you look at indexes, said Victor Lin, a Credit Suisse strategist. A lack of lockstep moves has been one of the market’s signature qualities for the last few months, pushing correlation to a five-month low.
“The correlation between stocks helps dictate how much single stock volatility manifests at the index level,” Lin wrote in a note this week. “When correlation is higher, index volatility is closer to the average single stock volatility. However, in a low correlation regime, index volatility is significantly lower than average single stock volatility.”
(as a reminder, implied correlation infers the relative volatility between the index and its underlying components – the lower the correlation, the higher the relative individual risk is to the index)
“You have these two forces pushing against each other, strong economic fundamentals and a volatile news cycle, with talks of trade wars,” said Todd Fungard, who oversees $1.2 billion as chief investment officer of McQueen, Ball & Associates Inc.
“The market is up, which is reflecting the fundamentals, but the defensive posture is reflecting people’s caution.”
However, as Deutsche Bank warns, trade wars and tariffs in their early stage act as a source of temporary disequilibrium. The underlying dislocation raises the level of contingency and is supportive for volatility.
Trade wars inject temporary volatility and dislocate markets as search for a new equilibrium takes place. Tariffs create market barriers; they raise the price of imports and, therefore, pose a threat to profits of exporting economies.
With trade wars and tariffs being a destabilizing force and a possible catalyst for a risk-off trade, there could be continued threat of bullish reversal at the long end of the volatility curve. At the same time, the inflationary overtones of these same tariffs and their possible interference with growth could take the economy in the unwanted direction where it would be difficult to find an adequate monetary policy response.
We believe that the Fed is likely to continue its course without excessive concerns about what their hikes could do for EM. The current tensions are likely to be resolved through the currency channel with different effects across other market sectors. We expect volatility to start in the EM and, depending on the subsequent developments, it could spread to risk assets and possibly developed markets.
For now, it is Oil and high yield credit markets that remain at elevated risk levels while, rates and FX have fallen back with stocks as the trade war escalates…
Finally, Bruce Bittles, chief investment strategist at RW Baird in Florida, sums it all up well:
“Investors are worried, but when you see the Nasdaq make a new high, that’s lot of speculative juices there…”How deep is the worry?””
Not deep enough we suspect.
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