Volatility is here and set to spread.
That’s the view from Wall Street, which holds that Tuesday’s rebound in risk assets from the biggest decline in the S&P 500 Index of 2019 is just a lull in what has traditionally been a rocky month.
Selling sparked by forced adjustments among systematic investors and a plunge in global equity sentiment combine with the seasonal pattern of volatility to thoroughly alarm Masanari Takada, cross-asset and quantitative strategist at Nomura.
“It would be a mistake to dismiss the possibility of a Lehman-like shock as a mere tail risk,’’ the strategist warned.
The S&P 500 plunged 3% Monday after China let its currency weaken to the lowest in 11 years, sparking fears that the trade war had entered a more unpredictable stage. Treasuries surged with gold and the yen on demand for havens. Risk assets bounced back somewhat Tuesday after Beijing strengthened the yuan, but investor nerves remained frayed.
“The waters appear to be as opaque now as they were in the fall of 2015 when China hard-landing fears defined global risk markets (if for different types of reasons),’’ Michael Purves, chief executive officer of Tallbacken Capital Advisors LLC, wrote in a note to clients. “Accordingly, dip buying will be tricky in the near term, and we expect volatility will be elevated, until valuation resets handsomely (such as it did in December).’’
The Cboe Volatility Index slipped to 22 Tuesday after almost hitting 25 a day earlier. It has averaged 15.6 this year. In the short term, that means markets will have to digest an onslaught of selling from funds that will now be deleveraging to realign their exposure to equities based on a set level of market unrest.
“Call it a few tens of billions of equities to sell over the next couple of sessions,’’ said Benn Eifert, chief investment officer of QVR Advisors.
So far, institutional selling of short-term puts in equities -- which has the effect of dampening stock volatility -- hasn’t reached nearly the same scale as in the fourth quarter or May drawdowns, according to Eifert. This smaller supply of downside volatility on offer has been a partial contributor to the magnitude of the VIX’s recent surge.
The acute reaction in equity volatility prompted Macro Risk Advisors to recommend alternative methods to protect against a further stock sell-off. Derivatives and quantitative strategist Maxwell Grinacoff suggests targeting exchange-traded funds that focus on gold and its miners.