In an overnight note by Goldman's Ian Wright titled "Calm before the storm", which looks at pricing of risk during the current low-vol episode, the GS strategist writes that in the run up to the inauguration last Friday of the 45th President of the US, investors have remained keen to discuss all things at the intersection of President Trump and markets. And yet, despite the uncertainty, volatility has been very low, which is why Goldman tries to estimate which assets appear the most fragile in the event that volatility picks up.
Goldman uses three frameworks (valuation, vol-adjusted move sizes, and return distribution tail widths) and its forward-looking overlay to assess which asset classes appear "most vulnerable to substantial repricing." This is what the bank found:
"We do not see any asset classes as particularly “stable” at this point in time. In our view, at an asset class level, both credit and FX seem the most vulnerable by most metrics. In addition, at an individual asset level, German and UK rates and the S&P 500 appear most vulnerable."
Some more details from Goldman:
Valuation: In our view, the assets with the most stretched valuation have negative asymmetry, i.e. more downside than upside; but this does not mean they will reprice down, as valuation alone is seldom a catalyst for repricing. Exhibit 1 shows the percentile of current valuations across assets relative to their historical distributions since 2003. The S&P 500, European HY and non-US government bonds appear the most stretched by this metric, but few assets appear particularly “cheap”.
Bund yields will largely depend on the reflation picture in Europe, as well as what happens to US yields; both of these we expect will drive Bund yields higher. In addition, should the resilience of UK data continue, Gilts have the potential to reprice meaningfully (even our base case has Gilts at 1.90 at 2017YE). Regarding the S&P, given the uncertainty around tax policy, there is potential for repricing both up or down. We think potential for disappointment is high given optimism and bullish sentiment. It is hard to see other equity markets not responding negatively amid a significant sell-off in the S&P, but in the case of a gradual move down, we think other markets could likely bear it.
Vol-adjusted move sizes: We measure the number of 3-standard deviation moves each asset has had, using recent realized volatility to measure standard deviations. Exhibit 2 plots the share of 3-standard deviation days that have happened in the past year in each asset class, as a fraction of the total across asset classes. FX and fixed income stand out as having had the most extreme moves recently. While this is based on backward-looking measures of volatility, we expect FX to remain volatile, both in function of monetary policy divergence and political risk.
Distribution tails: For return distribution shapes we look at what assets have the largest return distribution tails. Exhibit 3 plots the width of the bottom and top deciles of each asset class’s past 3m realized return distribution, normalized by their 1y standard deviation. Based on that measure both FX and Credit stand out as most vulnerable. This is unsurprising given this is related to our previous metric, but also shows the downside tail has been much more substantial for credit than the upward tail, more so than for any other asset class.
Bottom line: according to Goldman, if vol were to pick up, virtually every asset class, starting with US equities, European junk bonds, and especially FX, is a candidate for a sharp repricing lower.