Morgan Stanley calls them “rolling bear markets“; to others they are just occasional sharp, sometimes harrowing, price drops across various asset classes which however fail to drag down the entire market.
Starting in January with the sharp spike in rates, then continuing with a big drop in tech names, a spike in Italian bond yields which then morphed into an EM selloff and commodity plunge due to trade wars, the sequence of selloffs culminated last week with the sudden rise in US rates during the first week of Oct which led global risk assets to sell off pushing cross asset risk metrics higher over the month.
Meanwhile, continued concerns around Italy have caused the Italian-German bond spread to trade at 5y highs and added pressure to European assets. But while rates have arguably been a major source of risk this month, global rates vol is still the least stressed cross asset vol historically. And since that may change if Morgan Stanley – which warned today that current market conditions are dangerously similar to what happened in the fall of 1987 – Bank of America notes that with most hedge costs still comfortably below long term median levels, it remains historically inexpensive to hedge.
Before we look at BofA’s hedging suggestions, a quick walk through the main risk events we have observed in 2018, when markets have been considerably more shock-prone in 2018 compared to last year. As BofA’s Benjamin Bowler notes, of the 34 assets in the bank’s screen, six have experienced a top-10 drawdown year-todate, up from none in 2017 (Chart 3).
And as Morgan Stanley has repeatedly discussed in recent months, the sources of these shocks have spanned multiple regions and asset classes: the five prevailing risk themes for 2018 YTD, along with assets closest to these sources of risk, are shown in Chart 4. These are i) US interest rates-led sell offs; ii) tech stocks “hedge fund hotels”, iii) political instability in Italy; iv) jittery emerging markets, and last but not least, v) trade wars.
To be sure, the chart above does not represent an exhaustive list of risk sources or at-risk assets, and in some cases multiple assets can be considered as barometers for a given risk (e.g., Trade wars, EM weakness). On the other hand, there are known risks that simply have not flared-up thus far this year. For example, the possibility of a ‘no-deal’ Brexit – while clearly a risk for markets – has not led to specific large drawdowns for major assets YTD.
Which brings us to BofA’s second, and for investors more critical point: how to hedge against these (recurring) risks, and more importantly, do so cheaply.
Using the representative assets in Chart 4, Bowler identified drawdown periods relating to each of the five sources of risk (shown as shaded regions in the chart). He then calculated crash returns during these five periods for 35 cross-asset hedges relative to their current 3M 25-delta implied volatilities. The results are as follows:
- NIKKEI and FTSE puts screen as best value for a US rates-led risk-off event
- NDX and S&P500 puts screen well for US Tech concerns
- SX7E and EURUSD puts rank as good value Italian sovereign hedges
- HSCEI and CADUSD puts rank best for hedging further EM downside
- Copper and HSCEI puts screen well for potential trade war escalation
- Overall, puts on EM equities (KOSPI, HSCEI, HSI and EEM) and commodity-linked assets (Aluminum, Copper and AUDUSD) screen as best value based on their average hedge benefit across the five risk-off periods we have identified
And shown in table format:
Finally, before showing the full hedging screen, it is worth noting that the Feb-18 risk-off episode in which US 10y rates rose by almost 60bps precipitating a sell-off in US equities (and an unraveling of the short VIX ETP complex), also had a large effect on the majority of assets in the BofA screen. Specifically, the green markers in Chart 5 are most to the right for 12 out of 35 assets. Given the most recent spike in US rates on 3-Oct, Bowler’s warning to BofA clients is simple: “it is timely to seek efficient hedges for another potential spill-over of US rates into broader markets.“
via RSS https://ift.tt/2RFcrl5 Tyler Durden