SINGAPORE (Feb 19): The market is consistently proving that everybody can be wrong. Global equities got hammered badly in the first few trading days of February, wiping out 2018’s entire year-to-date gain amid soaring volatility and the resulting panic selling. Just a few weeks ago, the market was euphoric as macroeconomic data continued to improve globally, underscoring a strong -global cyclical upswing. The biggest risk does not come from fundamentals; it comes from within — complacency and overlooked volatility.
On Feb 5, the widely used “fear gauge” — the CBOE Volatility Index — surged to an eye-watering level of 49.2, a level not seen in more than six years (see Chart 1). The highest level for VIX was in 2008 during the subprime crisis, when it was around 80. Heightened risk-aversion led to the fiercest market correction seen since the 2011 European financial crisis and the impact could reach far beyond the current damage — confidence can get badly shaken.
The overly suppressed volatility was like a dormant active volcano, which erupts from time to time. Owing to heightened market volatility during a short period of time, an exchange-traded note issued by Credit Suisse, which allows investors to short volatility, collapsed. It lost 96% of its value overnight, following a 1,600-point plunge in the Dow Jones Industrial Average, causing the issuer to adopt early redemption of the note and the suspension of a dozen volatility-linked exchange-traded products.
According to Bloomberg, several large issuers have created more than US$8 billion ($10.6 billion) of products tied to the VIX — both long and short. Moreover, the turmoil in the VIX will spur a wave of deleveraging among volatility-targeting funds that is set to unleash US$225 billion of equity sales in the following days, Barclay estimates. About US$500 billion of assets are tied to funds that target a given level of volatility, two-thirds of which are traded by algorithms that look poised to divest after Feb 5’s eruption of turbulence.
The global short volatility trade represents an estimated US$2 trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility. Volatility is now an input for risk-taking and the source of excess returns in the absence of value. This situation cannot be sustained as, when everyone is on one side of the volatility boat, it is much more likely to tip over.
Markets have long been ignoring the tightening monetary policy factors — which are negative for equities and liquidity — until recently, when they attempted to price in all the factors at once. The rout was also a warning for hedge funds and institutions that keep shorting market volatility, taking it as easy money. Again, the market proves to us nothing is free.
Where are equities heading after the volatility shock?
So, is the equity market rout finally over? Or is a deeper correction needed until the market strikes a balance between the current rich equity market valuation and a rising interest rate environment? I believe it is a matter of time before markets start to calm down and refocus on earnings and fundamentals, which are delivering positive surprises. There is no clear sign of systemic risks developing and stock market crises are unlikely to happen when economies are expanding and earnings are improving.
Bloomberg’s analysis of the Standard & Poor’s 500’s median price return after a one-day decline of at least 4% during non-recession years since 1928 suggests some consolidation may occur over the coming week before the equity rally resumes, ultimately returning around 14% in the following 12 months (see Chart 2).
In Singapore, the Straits Times Index has retraced more than 6% to the 3,380 area from its recent peak of 3,611 points at end-January. The downside, however, is likely to be cushioned by improved fundamentals and relatively low valuation. Therefore, value investors should have confidence about the market outlook beyond this correction.
In Hong Kong, the Hang Seng Index has tumbled nearly 4,000 points, or nearly 12%, to the 30,300 area from its all-time high of 33,484 points not long ago (see Chart 3). The index is trading beneath its 50-day simple moving average (SMA) line, which proved to be a good support level for the past four technical corrections observed in 2017. Technically, momentum indicator MACD, or moving average convergence divergence, is still trending lower and RSI, or relative strength index, has reached the oversold zone below 30%. More consolidation is possible in the days to come, owing to inertia selling until the market reaches equilibrium again.
US dollar freefall has bottomed out
The freefall of the US dollar has finally stopped. After a two-month decline, the US Dollar Index March contract has bottomed out at the 88-to-89 area and since rebounded to 90.2 (see Chart 4). Trend Indicator SuperTrend (10,2) has flipped upwards for the first time since end-December, with the 10-day SMA line sloping upwards. Both suggest the trend has turned bullish.
Fundamentals are also supportive of a stronger US dollar, with a robust job market and inflationary pressures the key drivers for more rate hikes this year. Tax reform and infrastructure spending are potential boosts to the US economy and will attract more overseas funds to be repatriated to the country — all suggesting a stronger currency.
The EUR/USD has retraced to a 100% Fibonacci Extension level of 1.228, with its immediate support and resistance level at the 1.220 and 1.238 areas respectively. The trend has turned bearish, with its SuperTrend and 10-day SMA both flipped downwards. The USD/JPY has found strong support at the 109.0 area and its near-term trend has turned bullish. The next key resistant level can be found at the 111.3 area.
Margaret Yang is a market analyst at CMC Markets Singapore
