Wobbling US stocks could push volatility-linked funds to ramp up selling
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[April 18, 2024] By
Saqib Iqbal Ahmed
NEW YORK (Reuters) - Volatility-linked investment strategies are joining
the nascent sell-off in U.S. stocks and could help accelerate declines
if market gyrations keep increasing.
Volatility control funds - systematic investment strategies that
typically buy equities when markets are calm and sell when they grow
turbulent - hoovered up stocks as the S&P 500 marched to record highs
this year.
With the S&P 500 now off more than 4% from those levels and the Cboe
Volatility Index near its highest point since October, some of these
funds are once again becoming sellers.
Though the S&P 500 is still up about 5% year-to-date, further gyrations
could trigger more selling from the funds: analysts at Nomura estimate
the strategies could dump some $45 billion worth of stocks if the S&P
500 averages daily moves of 1% over the next two weeks.
"Their positioning is clearly above average,” said Parag Thatte, a
strategist at Deutsche Bank. "There is room for them to pull back in
terms of exposure."
Nomura's Charlie McElligott estimates that volatility control funds have
already started selling, shedding about $16.2 billion in equity exposure
over the last week.
While that is small compared with the S&P 500’s $42 trillion market
capitalization, the funds’ tendency to follow market momentum can
sometimes exaggerate stock moves, market participants said. Other,
slower moving strategies could also join in if volatility increases.
The market's recent swings were preceded by a long period of calm in
which investors piled in to equities, driven by evidence of
strong-yet-stable economic growth and expectations that the Fed would
deliver several rate cuts this year. The VIX has not risen over the 20
mark - a level associated with healthy demand for portfolio hedges - for
120 sessions, the longest such streak since 2018.
Stock gyrations have increased in recent weeks as hopes for rate cuts
fade in the face of stronger-than-expected inflation. Those worries have
been exacerbated as a spreading conflict in the Middle East drives up
oil prices, threatening to push inflation higher.
Volatility has picked up in other asset classes as well. The MOVE index,
measuring expected volatility in U.S. Treasuries, stands at a
three-month high following a steady rise in Treasury yields. The
Deutsche Bank FX Volatility Index, a measure of currency market swings,
has climbed to a near 10-week high in the face of a rally in the U.S.
dollar.
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"The volatility increase we're seeing is across asset classes," said
Mandy Xu, head of derivatives market intelligence at Cboe Global
Markets. "I think it is the market waking up to potential downside
risk."
One reason that selling from volatility-control funds has not kicked
in to higher gear so far is that the declines in the S&P 500 have
been relatively measured, Barclays strategists wrote.
However, “the funds are quite susceptible to a massive unwinding
from the currently high level of equity allocation, particularly if
volatility reprices higher in case inflation keeps surprising to the
upside, limiting the Fed's ability to cut rates," according to
Barclays.
Volatility control funds have a relatively short fuse compared with
other computer-driven strategies, making them among the first to
react when the market landscape changes.
A more pronounced jump in volatility could also activate
slower-reacting funds that use volatility as a trading signal,
including commodity trading advisers and risk parity funds, piling
more pressure on the market as they ramped up selling.
Nomura’s McElligott said CTAs could sell some $31 billion in
equities if the S&P 500 falls another 2% to around the 4,914 level
in the weeks ahead.
One catalyst for such moves could be corporate earnings season,
which kicked in to gear last week. Investors next week will be
bracing for earnings from a slew of technology and growth
heavyweights, including Tesla, Meta Platforms, Microsoft and Google
parent Alphabet. The U.S. will also get a look at another inflation
measure on April 26, when the personal consumption expenditures
index is released.
"Volatility control has been the larger force to date with regard to
systematic deleveraging ... during this choppy pullback," McElligott
said. "CTAs join the party in the coming weeks if weakness
persists."
(Reporting by Saqib Iqbal Ahmed in New York; Editing by Ira
Iosebashvili and Matthew Lewis)
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