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Lisa Majmin INTERNATIONAL FINANCE CORP 247886
EUROPEAN INVESTMENT STRATEGY
January 9, 2014
In this Issue: F Low Volatility Doesn’t Last ............ 2
F Why Stability Is Unstable ................. 3
F The Best Way To Trade Volatility ........ 4
F Is There Too Much Complacency In The Euro Area? ............... 5
Periods of low stock market volatility sow the seeds of their own destruction, because they encourage complacency and an under-pricing of risk.
Buy the near month VIX contract and simultaneously sell the far month contract when the futures curve is upwardly sloping (taking into account the bid-offer spreads).
Two important indicators will track whether the euro area’s main imbalances are correcting: higher labour cost inflation in Germany compared to the other major euro area economies, and a converging distribution of bank lending rates across the euro area.
Maintain a holding in the aggregate euro area sovereign bond…
…and a long Eurostoxx, short S&P 500 equity market pair trade.
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VOLATILITY OFDOW JONES INDEX*
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*ANNUALISED STANDARD DEVIATION OF MONTHLY RETURNS OVER ROLLING 12-MONTH PERIODS.
If there is a universal truth in economics and financial markets it is that periods of subdued volatility do not last. This is true for the economy, but it is especially true for the stock market.
Volatility has no long-term trend and always and inevitably mean-reverts. Furthermore, this result is remarkably consistent across different geographies and economic eras spanning years, decades and even centuries1 (Chart of the Week, Chart 2 and Chart 3).
Nevertheless, the powerful evidence of volatility’s long-term constancy does not prevent a com-mon delusion. An extended period of low volatility has frequently seduced leading politicians and economists into complacency – that economic and financial market instability has been conquered.
Barely a week before the Great Crash of 1929, Yale University’s Professor of Economics Irving Fisher famously predicted that “stocks have reached what looks like a permanently higher plateau”. More recently, Ben Bernanke’s self-congratulatory 2004 speech titled The Great Moderation claimed that recessions had become less severe because of “improved-monetary policy”. And Britain’s former Chancellor and Prime Minister, Gordon Brown, infamously boasted in 2007 that “we will never return to the old boom and bust”.
1 G. William Schwert of the University of Rochester shows stock market volatility going back to 1802 at www.schwert.ssb.rochester.edu/volatility.htm
Periods of subdued volatility do not last.
Lisa Majmin INTERNATIONAL FINANCE CORP 247886
european investment strategy - weekly report january 9, 2014BCa researCh inC.
Why Stability Is UnstableOf course, in each case volatility did mean-revert with a vengeance, and an excellent explanation why comes from Hyman Minsky’s Financial Instability Hypothesis. Put simply, periods of low vola-tility sow the seeds of their own destruction, because they encourage complacency and an under-pricing of risk.
As a period of stability extends, more and more people – including policymakers – become convinced that it is permanent. This allows valuations of revenue streams to become richer, and financing arrangements to become riskier.
The Minsky cycle begins with hedge finance when borrowers’ expected revenues are sufficient to repay interest and loan principal. It then moves on to speculative finance when revenues cover interest. And it escalates to Ponzi finance when revenues are insufficient to cover interest payments – bor-rowers are entirely dependent on capital gains to meet their obligations. The cycle ends violently with a so-called Minsky moment – a small drop in asset prices that tips the marginal Ponzi financed borrower into insolvency and triggers a widespread corrective phase of de-levering and re-pricing.
Although Minsky focussed his instability hypothesis on the economy, we can draw very strong paral-lels in the stock market. An unusually extended period of subdued volatility – like now – encourages an under-pricing of risk for three reasons:
Volatility has no long-term trend and always and inevitably mean-reverts.
Lisa Majmin INTERNATIONAL FINANCE CORP 247886
european investment strategy - weekly report january 9, 2014BCa researCh inC.
1. Many asset allocation models – such as mean-variance optimisers – use past vola-tility as a predictor of future equity market risk, but tend to put a much greater weight on recent history than on distant history. In other words, just as Minsky points out, investors complacently expect the low recently experienced volatility to persist indefinitely and forget the long-term mean reversion.
2. This expectation of low volatility, and hence smaller drawdowns, emboldens equity investors to take on greater leverage. For example, note that NYSE margin debt (as a share of GDP) is approaching an all-time high.
3. Subdued volatility normally implies an extended uptrend in stock prices. And in an industry where calendar quarter perfor-mance determines your livelihood, fund managers simply cannot afford to be under-invested – irrespective of their long-term view of valuations. As more and more long-term bears are forced to capitulate, there is no longer a healthy balance of views to price equity market risk.
The Best Way To Trade VolatilityDoes all of this mean investors should buy volatility today? For those wanting insurance for an imminent large spike in risk, the answer is perhaps yes. But for anybody looking for a profitable investment opportunity, it’s not that simple. Unlike most financial and physical assets, it is impos-sible to buy or sell the spot volatility indices like the VSTOXX, VDAX or VIX. Instead, investors have to buy derivatives of these indices – either futures or options. And unfortunately, this means they will be exposed to the pricing vagaries of these derivative instruments.
Specifically, when spot volatility is low everybody expects it to rise. Hence, the futures price is in contango, which is to say more expensive than the spot price. Indeed, the lower the spot, the greater the contango. Such an upward sloping futures curve can make a buy-and-hold volatility strategy prohibitively expensive. For example, if spot volatility stayed unchanged for a month, the one-month future contract would roll down the curve and expire at a loss. Clearly, repeating this strategy month after month would make it a very costly trade.
Periods of low volatility sow the seeds of their own destruction, because they encourage complacency and an under-pricing of risk.
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VIX FUTURES:FAR-MONTH / NEAR-MONTH
VIX SPOT INDEX
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When Volatility Spikes, The Futures Curve Inverts Sharply...
Luckily, there is a much better way to trade volatility. Whenever the futures curve is upwardly sloping (after taking into account bid-offer spreads), investors shouldn’t trade volatility per se, but instead trade the steepness of the volatil-ity futures curve. In practical terms this means buying the near month futures contract while simultaneously selling the far month contract.
The theory behind this strategy is that when risk eventually flares up, the futures curve tends to invert sharply – go into backwardation – as a market in panic puts much higher value on immediate protection (Chart 4 and Chart 5). So the gain on the long near position is much greater than any loss on the short far position. On the other hand, if volatility remains low, the monthly expense is minimised as both the long and short positions roll down the futures curve by near identical amounts. Therefore, with or without an imminent spike in risk, the strategy leaves open the possibility of large profits while reducing the penalising monthly rollover costs.
We are opening this strategy today on the VIX in preference to our current position on the VSTOXX, which we are closing at a small profit.
Is There Too Much Complacency In The Euro Area?If stability sows the seeds of its own destruction, then the euro area might seem the top candidate for trouble. Over the last few years, euro area policy makers have pushed through painful but es-sential structural adjustments only when under intense pressure from financial markets. But with a fledgling recovery underway in the economy and a long period of calm in the markets, is the structural progress at risk of stalling in 2014?
To answer this question, it is necessary to to define progress. First, it is important to recognise that the aggregate euro area remains relatively balanced. Indeed, as Mario Draghi recently pointed out:2
“If you look at the euro area from a distance, you see that the fundamentals in this area are prob-ably the strongest in the world. This is the area that has the lowest budget deficit in the world. Our aggregate public deficit is actually a small surplus. We have a small primary surplus of 0.7%, compared with, I think, a deficit of 6 or 7% deficit in US and 8% in Japan. This is the area with
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...The Near-Month Volatility Future Rises More Than The Far-Month
the highest current account surplus. And it is also the area with one of the lowest – if not the lowest – inflation rate.”
Even the euro area’s weak suit, employment, does not appear so bad based on the employ-ment to population rate (Chart 6) – which takes into account the euro area’s structurally rising participation rate.
Therefore, the main euro area imbalances that must be corrected are not external, but internal. Specifically, to justify a common exchange rate and interest rate for euro area nations, the com-petitiveness gap between Germany and the other major economies must continue to narrow (Chart 7 and Chart 8). Just as important, the fragmenta-tion of the financial system – which has created a large disparity in financial conditions across the euro area – must continue to reverse.
The euro area’s weak suit, employment, does not appear so bad based on the employment to population rate.
Convergence
Spain
Less competitive
Germany
More competitive
Spain
Germany
Productivity plus inflation
Italy
France
Lisa Majmin INTERNATIONAL FINANCE CORP 247886
european investment strategy - weekly report january 9, 2014BCa researCh inC.
Hence, two important indicators will encapsulate the euro area’s on-going adjustment through 2014 and beyond: higher labour cost inflation in Germany compared to the other major euro area econo-mies (Chart 9), and a converging distribution of bank lending rates across the euro area (Chart 10). As long as these two indicators confirm that the euro area’s internal imbalances are correcting, we will maintain our holding in euro area sovereign bonds and our long Eurostoxx, short S&P 500 equity market pair trade.
* posITIvE pERCEnTAgE ChAngE dEnoTEs AppRECIATIon vERsus ThE us doLLAR. ** BAsEd on 10 gICs sECToRs; ExpREssEd In LoCAL CuRREnCy TERMs; souRCE: MsCI InC. (sEE LAsT pAgE).
F Ian MacFarlane, Managing Editor F Mark McClellan, Managing Editor F Francesca Beausang-Hunter, Associate Editor F Aleksandra Buimistere, Research Assistant
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