- After a mid-August downturn, markets remain unsettled and volatility remains elevated …
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- … but, over the past year, elevated volatility has been positively correlated with strong forward returns.
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- The risk of sharp and swift downturns in risky assets remains, fuelled by high equity valuations, elevated rate volatility and questions about forward growth, in particular in China.
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- As the global cycle enters the Slowdown phase, the frequency of drawdowns may increase, as future prospects become less transparent …
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- … but, historically, after the initial fall, stocks tend to regain most, sometimes all, of the lost ground within the next 3 to 12 months.
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- The August equity selloff was one of the swiftest on record …
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- … with limited low cross-sectional dispersion of returns and limited apparent macro profile.
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- If equities are to continue to recover, the key is a stabilization of growth.
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1. Market overview
Yesterday, it was the turn of a market uptick: after Tuesday’s sharp losses, the S&P 500 was up 180bp, amid relatively light trading. Oil prices registered a similar rally, with a 180bp gain coming on the heels of the previous day’s very large 770bp slide. The Dollar broadly strengthened as well, and yields in the US sold off a couple of basis points. The VIX index also eased slightly, once again closing below the 30 mark.
Wednesday’s macro data pickings were relatively meager. At 190K, the August ADP National Employment Report was a touch below expectations. The Fed’s Beige Book, an anecdotal summary of business conditions reported by regional banks, was consistent with continuing expansion.
Noteworthy data releases and events over the next few days include Service PMI releases for most major economies, the ECB meeting today and the US non-farm payrolls release on Friday.
2. Bull market interrupted, once again
After a remarkably quiet period earlier this year, the US equity market, alongside other key global markets, has hit some rough waters over the last few weeks. In a period of little more than a week, the S&P 500 and Germany’s DAX indices retreated around 12%, Chinese H-shares fell around 14%, US 10-year yields rallied close to 2%, and oil prices fell sharply to below $30/bbl. Since then, markets have regained some of the lost ground, but volatility remains elevated and daily price seesawing continues. After languishing in the low-teens for the better part of the year, the 'fear factor' index, also known as the VIX, spiked to above 40 during the height of the market downturn and remains elevated. This marked only the seventh episode in its quarter-century history when it has broken the 40 mark, but – at least so far – it did not stay there for more than a single day.
We often refer to these sharp and sudden downturns in the market as 'drawdowns' (see Global Economics Weekly: Equity drawdowns: Bull market interrupted, not the dawn of a new era, July 10, 2013). Drawdowns represent a measure of maximal 'pain' that holding a position inflicts, defined as the most negative peak-to-trough move over a period of time. While it is intimately related to other measures of risk, it more explicitly expresses what stands to be lost when holding a particular position.
Earlier this year, we wrote about an elevated risk of 'drawdowns' (see GOAL: Upgrading credit to Overweight; heightened equity drawdown risk, Mar 27, 2015), fuelled by a confluence of higher rate volatility, high valuations, the Greek crisis and worries about EM growth. Indeed, it appears that one of the main catalysts for the current drop is concern surrounding China growth. While market pullbacks of the magnitude we just witnessed do occur, they are relatively rare outside of recessions, and, as we will outline below, often lead to positive returns in subsequent months. Over the last year in particular, elevated volatility was positively correlated with strong forward returns (see Global Macro Risks in Focus: Risk off moves turning indiscriminate, Aug 25, 2015, Exhibit 14).
3. Drawdowns abound in Slowdown
Over the past 25 years, the median drawdown of the S&P 500 index over a period of one month has been around 3%, and 5.5% over a quarter. Not surprisingly, they are the most common and the most violent during the Contraction phase of the business cycle, when growth is falling at an accelerated pace, and the most benign during the Expansion phase, when growth is positive and sequentially improving.
According to our Global Leading Indicator (see Global Leading Indicator: August Final GLI – Slide into Slowdown, Sep 1, 2015), the global cycle is currently in the Slowdown phase, when global growth is positive but sequentially weakening. When the cycle is in Slowdown, the median drawdown for the S&P 500 during a three-month period is around 5%.
Starting in 1985, there were 31 episodes of the S&P 500 falling by 10% or more during a period of at most two months. (We limited the 'window' over which we look for the worst peak-to-trough performance in order to study forward returns over longer horizons – from one quarter to one year – relative to the registered trough.) Of all of these sharp drawdown episodes, 35% occurred in Slowdowns, 30% in Recovery and Contraction, and only around 5% in Expansion.
Elevated incidence of sharp drawdowns in Slowdown is not coincidental. The Slowdown phase often tends to be 'opaque' and difficult to navigate. Indeed, it has two possible 'exits': one is back to Expansion and a return to strong positive trends, and the other is to extend downturn into Contraction and to result in further market weakness. It is no surprise, then, that significant (that is, worse than 10%) drawdown episodes happen most often during Slowdowns. This is even more exacerbated if we exclude recession periods when negative returns are a norm: outside of recessions, Slowdowns account for 2 out of 5 of 10%-or-worse drawdowns.
4. Once the storm passes, returns tend to improve too
Once the 'worst' of the drawdown is over, prices tend to recover over a period of time that is, for most global equity indices, roughly twice as long as the drawdown period itself lasted. On the face of it, this suggests that a week-long drawdown – more-or-less a period of time we went through in mid-August – will take two weeks to return back to previous levels. But there are some important caveats here. First, the current episode was among the 'fastest' on record – 'black Monday' in 1987, markets drops during the GFC and the European crisis in the summer of 2011 were the only instances when the market gave up 10% or more in less time than now. Second, there is substantial uncertainty around this estimate. And, third, the recovery period tends to get longer for deeper drawdowns. However, in defence of the '1-for-2' rule for the recovery period, it held reasonably well during various 'mini-drawdowns' over the course of last year.
More formally, after a drop of 10% or more in the S&P 500 index, median forward returns tend to become positive. Over all 31 instances of drawdowns we studied, and relative to the market trough, one-month, three-month and one-year forward returns were all positive, with the market returning to pre-drawdown levels between 3 and 12 months after the onset of the drawdown.
5. Current episode: Low dispersion of returns suggests low macro content
A cross-section of asset returns often contains information on the fundamental drivers of market moves, as the 'principal' market driver tends to be correlated with a spread between best-performing and worst-performing assets. The opposite is, however, also true: a lack of asset returns’ dispersion, or an unclear distinction between market winners and losers, suggests a lack of a 'principal' market driver, or an organizing theme that can explain market shifts. This is often the case in sharp 'risk-off' market moves that, while possibly reflecting pent-up pressures, often do not have proximate fundamental catalysts.
The current episode is one such example. Looking both at global equity indices and US equity sectors, the cross-sectional dispersion of equity returns was lower only two other times – once again, during Black Monday and during the European crisis in 2011.
In addition, there is the natural question: what is this episode like? A cross-section of asset returns can offer some suggestions here too: the correlation of returns between different episodes singles out the European crisis from 2011 as the past episode most similar to the recent experience, when the profile of equity returns turned out to be most similar to what we have observed now.
6. Is it over yet?
That, indeed, is the question. Past episodes of drawdowns outside of recession periods and market downturns over the past year suggest that these episodes tend to be relatively short-lived and lead to slow and gradual improvements over subsequent weeks and months. But that is, clearly, conditioned by decent global growth. The global cycle has slowed down over the last three months, and it continues to do so, buffeted among other things by questions about Chinese growth and by the overall softening of fundamental data. Thus, a possible equity recovery after the August squall is strongly linked to the stabilization of the global growth picture.
7. Tactical Trading Views
The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term ‘structural’ positions included in our ‘Top Trades’ list further below.
On Rates:
- Stay short 10-year US Treasuries and long 10-year Bunds, opened on 17 Jul 2015 at a spread of 153bp, with a target of 190bp and a stop loss of 130bp, currently trading at 139bp.
8. Recommended Top Trades for 2015
Longer-term structural views are expressed in our Top Trade recommendations. These are typically managed with a wide stop, and assessed on the basis of whether the fundamentals continue to support the medium-term investment theme.
- Stay long EUR/$ downside via 1-year 1.00/0.95 put spread (originally at 1.20/1.15 with a premium of 70bp EUR at initiation), expiring on 20 Nov 2015, opened at a spot EUR/$ of 1.253 on 20 Nov 2014, currently at 1.122.
- Close constant maturity 10-year US Treasury 3.00-3.50% ‘cap-spread’, funded by selling a corresponding 2.24-1.75% ‘floor spread’ , opened on 20 Nov 2014, for a potential return of 0%.
- Close long Dec-2015 Eurostoxx 50 3150/3450 ‘bull’ call spread on 19 Feb 2015, opened at 101.5 on 20 Nov 2014, for a potential payout of c1.8-to-1.
- Close long risk on the 5-year CDX HY 23 junior mezzanine tranche (the 15-25% portion of the loss distribution) on 6 Apr 2015, opened at 495bp on 20 Nov 2014, for a potential unlevered gain of 5.2%.
- Close long basket of EM crude oil importers stock markets, implemented via equal part of TWSE and NIFTY indices (XU030 closed as of 1 Apr 2015), opened at 100 on 20 Nov 2014, for a potential loss of 8%.
- Close short CHF/SEK on 15 Jan 2015, opened at 7.70 on 20 Nov 2014, for a potential loss of 16.5% including carry.
- Close short Dec-15 LME Copper futures and long Dec-15 LME Nickel futures on 23 March 2015, for a potential gain of 0.3% on the relative value trade.
- Close long USD against a basket of HUF and ZAR on 21 Jan 2015, opened at 100 on 20 Nov 2014, for a potential gain of 8% including carry.
- Stay long USD against a basket of ZAR and KRW (on a spot basis), opened at 100 on 3 Feb 2015, with a target of 115 (extended from 110) and a stop on a close below 97.5 (raised from 95), currently at 112.8.
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