Top Themes for The Week (02/04/2018)



Last week's 4% equity market selloff was accompanied by a spike in interest rates, volatility, and correlation. Those who followed our recommendation to be long VXX until it is solidly above $30 saw a quick 19.1% gain this week and those who positioned for higher SPX implied correlation with reverse dispersion trades or correlation swaps discussed in our 2018 outlook, also saw large gains with 3-month  SPX Top-100 implied correlation going from 22.7% to 32.6% on the week. The graph below shows S&P e-emini futures (ES1) in white, I-Path S&P 500 VIX Short-term futures ETF (VXX) in orange, and the 10-year yield index (TNX) in green over the last 5 days:

Source: Bloomberg

Source: Bloomberg

Among the characteristics of this selloff were:

  1. Initial complacency, relatively low skew, and volatility selling earlier in the week where VXX was sold down to $28 as S&P seemed to initially stabilize), probably exacerbating the vol super-spike on Friday.  VIX options volume printed at an amazing 4.34mm contracts on Friday with 597k of the Feb 25 calls and 533k of the March 25 calls trading and the VVIX was up 18.7% on the day.  Volatility spreads such as the VXN/VIX and VXXLE/VIX had already closed at wide levels (6.44 and 8.32) going into the week and collapsed to 3.35 and 5.90 given the bigger vol demand for the VIX.   
  2. Bad response to rising interest rates/inflation fears, especially after the FOMC minutes and the higher than expected average hourly earnings Friday. 
  3. We had bad earnings reactions in several high-profile US names (AAPL -4.3%, GOOGL -5.3%, XOM -5.1% on earnings) as well as Europe which offset the positive news from AMZN (+2.9%). 
  4. The Nunes memo that questions the methods the FBI and Justice Department used to get a warrant to wiretap Carter Page was another negative Friday. 
  5. Underperformance of cyclical and high-beta sectors. The 6.5% rout in Energy (XLE) in the past week was an example of an exit from cyclical sectors that included Materials (XLB -5.7%)  and Semiconductors (SMH -4.7%) challenging the consensus view going into this year of positioning for "synchronized global growth." We had made a high conviction call for clients to get out of the high-beta factor two weeks ago and this worked well with SPHB (S&P high beta) underperforming SPLV (S&P low volatility) by another 169 bps on the week in addition to last week's 90 bp underperformance. 
  6. Healthcare had a sharp selloff, with XLV down 5.1% on the week. On Tuesday, Express Scripts, Cigna, Anthem, Mylan, and United Healthcare were all down over 3% after AMZN said it will work with BRK/B and JPM to form a non-profit providing healthcare to their employees with a goal of cutting cost. The escalating cost of healthcare was discussed by Warren Buffett and is making the electorate angry ahead of the mid-term elections, and it can again re-surface as a popular topic. Several healthcare analysts incorrectly defended the stocks that were down but we took the other side this week. If Amazon, for example, offers healthcare to their prime members at a discount and gets even a small percentage to sign up, this could be extremely disruptive and affect healthcare valuations. This week we will get a fair amount of high profile healthcare and biotech earnings with Bristol Myers on Monday, Gilead and Allergan on Tuesday, GlaxoSmithKline, Humana, and Sanofi on Wednesday and Regeneron, Alexion, CVS, and Cardinal Health on Thursday. 
  7. No asset class to hide as bonds, commodities, and real estate sold off with equities with increasing cross-asset correlation adding to the increase in stock correlation to increase portfolio risk. This can become problematic for those relying on diversification instead of explicit hedging for risk reduction in their portfolios, including balanced funds and risk-parity strategies, as well as any advisor implementing a strategy exclusively with long positions in ETFs. Also note that high yield (HYG) was down more in price than intermediate treasuries (IEF). 

S&P futures have broken below their 20-day moving average for the first time since November and broke down below support in the 2,760 area. If there is no bounce on Monday, or a very weak bounce to a lower high,  the next support level to target could be as low as 2,698/2,701 on continuing long liquidation (see chart below).  If there is a bounce in S&P, expect a quick pullback in the VIX/VXX from elevated levels.

Source: Bloomberg

Source: Bloomberg



Friday's average hourly earnings data actually steepened the US Treasury 5s/30s yield curve, which was a break with the prior strong flattening trend. The 19 bp rise in 10 year yields on the week was much higher than anything we could have imagined in any scenario and the bond market seems to have over-reacted to the actual news. We believe FOMC members are still set for a central scenario of three hikes this year and will not over-react to one employment number. Those who follow the Fed know that it has started to seriously look at the VIX and does not want to de-stabilize the system.  Adding to worries, the CBO said last week that the U.S. may run the risk of default without a debt-ceiling increase in the first half of March. T-bills maturing March 8th have had a risk premium priced into them and have yielded more than longer-term bills, creating a "hump" in the short-term yield curve.  

The rise in interest rates has hammered "income" areas of the market such as XLU, VNQ, USMV, and IYR which saw net outflows last week. These, along with other more "safe" and low volatility areas in the US seem better risk/reward here relative to high beta, cyclical, and international exposures. 

Implied yields in short-term cash management strategies such as SPX boxes and rev/cons continue to be attractive with very short times to expiration, especially for those who fear interest rate and credit spread risk and we have been active in this space. For example, the March SPX 1000-point box traded last week at an implied 2.19% annualized yield for a 46-day instrument guaranteed by the OCC compared to a 2.14% yield on 2-year notes and a 1.78% yield on NEAR (I-Shares Short Maturity Bond). 

We view the Nunes memo as another step in the escalation of US political risk. The rout in precious metals after Friday's inflation data seems excessive to us, especially in SLV (-4.6% on the week) and GDX (-5.9%) for which higher political risk, higher volatility, and bad news on bitcoin (CBOE Bitcoin futures -22% this week)  should eventually offset the negative impact of higher real interest rates. In addition to positioning long SLV and GDX in ETFs, buy/writes and OTM call ratio spreads can be considered with the recent uptick in implied volatility on OTM calls in metals and commodities in general.

In Europe, Deutsche Bank (ADR: DB), a name in which we had continuously recommended being long volatility, was down 12.4% after revenues were the lowest in 7 years. Note that 5-day and 20-day historical volatility in DB was 73.9% and 41.3% versus the DB March 18 puts coming into the week at 33.9% implied vol, highlighting the opportunities in US-listed options on ADRs, which we believe will continue.  Despite the DB rout, the SX7E (Banks) is still at the highest relative level versus the SX5E since August, as Italian and Spanish banks have rallied and many have been rotating to sectors benefitting from higher interest rates and not hurt too much by the stronger euro. 

Other European fundamental news has also been negative this week including Siemens which was down over 6% in 2 days. The German DAX which was considered a poster-child of “synchronized global growth” and a large over-weight in many portfolios because of their over-weight to Europe is now down 1% YTD, badly lagging SPX as we expected in our 2018 outlook and EWI and EWP were also down hard after a prolonged rally. 

Other areas in international markets that had been over-weighted and crowed going into 2018 on are also lagging SPY, including a selloff in EEM, down 5.8% on the week and INDA down 7%.