Stocks React as JPMorgan's Kolanovic Warns of Dual Threat: Extreme Low Volatility and Balance Sheet Reduction
Afternoon weakness in stocks is in part being attributed to a new note from JPMorgan's Marko Kolanovic. The strategist notes markets are facing two near-term known risks: extremely low volatility and prospects of central banks' balance sheet reduction.
First on extreme low volatility. Kolanovic comments:
"It is safe to say that volatility has reached all-time lows and this should give pause to equity managers. Low volatility would not be a problem if not for strategies that increase leverage when volatility declines. Many of these strategies (option hedging, Volatility targeting, CTAs, Risk Parity, etc.) share similar features with the dynamic ‘portfolio insurance’ of 1987. While these strategies include concepts like ‘risk control’, ‘crisis alpha’, etc. in various degrees they rely on selling into market weakness to cut losses. This creates a ‘stop loss order’ that gets larger in size and closer to the current market price as volatility gets lower. Additionally, growth in short volatility strategies in a self-fulfilling manner suppresses both implied and realized volatility. This in turn prompts other investors to increase leverage, and those that hedge with options lose out and eventually throw in the towel. The fact that we had many volatility cycles since 1983, and are now at all-time lows in volatility, indicates that we may be very close to the turning point."
Next on extreme monetary accommodation:
"Global Central Banks are likely to commence reducing their balance sheet accommodation (level for Fed, and inflows for ECB/BOJ) in the near future. We wrote about the impact of this ‘receding tide’ on market volatility and valuations (see here). In what is akin to the law of ‘communicating vessels’, once inflows in bonds stop, funds are likely to start leaving other risky assets as well, including equities. The FOMC statement yesterday alleviated immediate fears – normalization of balance sheet will start ‘relatively soon’, but only if ‘the economy evolves broadly as anticipated’. This reasonably dovish stance pushes this market risk out for a few weeks (the next ECB meeting is Sep 7th, Fed Sep 20th, BoJ Sep 21st). This gives volatility sellers and other levered investors a limited window to position for a seasonal pick up in volatility and Central bank catalysts in September."
Kolanovic also discussed the decline in Correlations and parallels to 1994 and 2001:
"Over the past year, correlation of stocks and sectors declined at an unprecedented speed and magnitude (Figure below). A similar decorrelation occurred on only 2 other occasions over the last 30 years: in 1993 and 2000. Both of those episodes led to subsequent market weakness and an increase in volatility (in 1994, and 2001). The current decline in market correlations started following the US elections and was largely driven by macro (rather than stock specific) forces. Expectation of Fiscal measures, deregulation and higher interest rates set in motion large equity sector and style rotations. For instance, the correlation between Financials and Technology dropped to all-time lows (similar level to during the tech bubble). The correlation between equity styles also dropped (e.g. Value was lifted by rates, and Low Volatility was impacted negatively). Declining correlations pushed market volatility lower (see here), and the ~25% market rally further suppressed correlations and volatility. To investigate what are potential implications for the future price action we look at the 1993 and 2000 decorrelation events."
1993/1994: Following the 1990-1 recession, interest rates declined and the market rallied. By late 1993, the market reached its highs (60% above recession lows) and volatility plummeted (VIX hit a record low on 12/22/1993). This also marked the low point of equity correlations. As interest rates increased in 1994, the market experienced a ~10% correction and posted a negative return for the year. Volatility and correlation increased, but the crisis was contained given the acceleration of growth (US GDP increased from 2.6% to 4.3% in the first half of 1994), and subsequent decline in bond yields.
2000/2001: Following the 1998 crisis (LTCM, Russia), the market recovered and continued to rally. When the internet bubble was inflated, the market was 60% above 1998 lows. This period was marked with a strong decoupling of sectors (e.g. tech vs. financials), distorted valuations, elevated volatility and gradually rising interest rates. It ended with the tech bubble in March 2001, which marked the low point of equity correlation and start of recession. Subsequently, the market declined ~30%, bottoming in late 2002.
The current episode of correlation decline shares some similar features to both 1993 and 2000. The decline of correlation was in part driven by the market rally and elevated valuations; after a period of falling, interest rates are expected to rise (as in 1993), sector valuations (e.g. Internet) and sector rotations play an outsized role in market price action (similar to 2000), and record low levels of volatility increased the level of risk taking (as in 1993). Normalization of monetary policy will most likely lead to an increase of correlations and volatility, and that will at some point result in market weakness. While it seems that the 1993/1994 analogy is more appropriate (implying an orderly price action), investors should be aware of hidden leverage and tail risk of a more significant correction, such as the one in 2001."