"Well, that escalated quickly."
That's how Morgan Stanley's chief cross-asset strategist Andrew Sheets summarizes events in the last week in his latest Sunday Start note, in which he describes how following one of the calmest stretches for stocks since the 1960s, an escalating war of words with North Korea hit late summer markets priced for relatively little vol with the result sharp and sudden: a 70% rise in the VIX index over three days, a 2% drop in global equities, and more than a few holidays disrupted. Fear not, though, because according to Morgan Stanley, whose outlook on the S&P is one of the most bullish on Wall Street, views last week's events "as a standard equity correction within an ongoing bull market." With volatility bearing the brunt of the repricing over the last several days, that’s where some of the most interesting changes lie.
And while Sheets lays out his reasons why the bank's advice to clients is just to BTFD - or in the context of N. Korea, BTFAONW - Morgan Stanley does caution that things could get serious if the one scenario many - most recently Jeff Gundlach - have been dreading, namely the rise in volatility, becomes self-fulfilling, with investors selling as volatility rises and markets move lower, driving more of both. As Sheets writes, "for this risk, I’d be watching if new lows in the S&P 500 are confirmed by new highs in the VIX. This scenario is also scarier if realised volatility can stay near implied (if it doesn’t, implied volatility can fall, reversing the cycle). As of noon Friday, 3m S&P 500 was priced for a daily move of 0.8% and EuroStoxx was priced for a daily move of 0.9%."
Finally, while the bank remains optimistic on equities, it adds that there is an exception: "we would not ‘buy the dip’ in US credit, where [we] see more risks, given weaker fundamentals, expensive pricing and limited upside in exchange for swimming against the recent tide."
Here is Sheets full Sunday Start note:
Well, That Escalated Quickly
Following one of the calmest stretches for stocks since the 1960s, an escalating war of words with North Korea hit late summer markets priced for relatively little vol. The result was sharp and sudden: a 70% rise in the VIX index over three days, a 2% drop in global equities, and more than a few holidays disrupted.
While the ‘why’ is worth discussing, the more pressing question is what happens next. For several reasons discussed below, we’d view this as a ‘standard’ equity correction within an ongoing bull market.
With volatility bearing the brunt of the repricing over the last several days, that’s where some of the most interesting changes lie.
Drawdowns happen. Since 1929, there’s always been a 30% chance that a 5%+ drop will occur at some point over the following three months. The S&P is off less than 2% from its all-time high, and (still) hasn’t seen a 5% correction since mid-2016, the longest such streak since 2004. Whether you’re bullish or bearish, I’d imagine there’s wide agreement that something like this would happen eventually. The bigger question is what’s driving the move. We don’t see it driven by a shift in fundamentals.
Let’s start with growth. Our economists continue to see solid global growth (4.3%Q SAAR in 2Q), which we believe will help to boost global equity EPS by double-digits this year. These views didn’t change in the last week, where, if anything 2Q DM earnings continued to surprise to the upside. If that’s right, it represents a key difference from the larger August drawdowns of 2011 and 2015. Watch China industrial production on Monday, where Morgan Stanley expects 7.5%Y versus consensus at 7.1%Y.
Policy also remains supportive, with real policy rates across the G3 still deeply negative. While there’s always a risk that the Fed’s upcoming conference in Jackson Hole will have a hawkish tone, that’s not our expectation and, if anything, our economists think the risk is tilted to Draghi sounding mildly dovish, given recent EUR strength. We forecast inflation to stay well below target across the G3 for another 4-5 months on our forecasts, providing flexibility to move policy slowly. Bigger risks loom next year, when higher inflation may take away this optionality.
Geopolitics is also fundamental. Relative to the five-year average, Korea CDS is 3bp higher while KRW is 3% lower. Korean stocks remain up 16% YTD, although volatility has almost doubled. These indicators are worth watching, but in aggregate it is hard to say they’re discounting an alarming scenario.
So, if it’s less about fundamentals, maybe recent moves are more technical. August is a month when more investors are out (or about to be out), lowering risk appetite and thinning markets. Even if more people were in, Korea is a legitimately hard risk to discount. And, as noted by Christopher Metli, in our Institutional Equity Division, there was an unusually high number of volatility shorts in the market heading into this week, which may help to explain (some of) the large swings in VIX. These moves have pushed the S&P 500 skew to its steepest levels on record.
That leaves two paths. One is that the rise in volatility becomes self-fulfilling, with investors selling as volatility rises and markets move lower, driving more of both. For this risk, I’d be watching if new lows in the S&P 500 are confirmed by new highs in the VIX. This scenario is also scarier if realised volatility can stay near implied (if it doesn’t, implied volatility can fall, reversing the cycle). As of noon Friday, 3m S&P 500 was priced for a daily move of 0.8% and EuroStoxx was priced for a daily move of 0.9%.
The other path, more likely in our view, is that this turns out to be a more ‘normal’ correction. The Morgan Stanley Global Risk Demand Index (GRDI*) has fallen to -3.6, an ‘oversold’ level seen only a handful of times over the last eight years. The volatility term structure has inverted, which has also tended to be a reasonable indicator of elevated fear. And we think there is capacity to add exposure eventually, especially in the US, where Prime Brokerage tells me net leverage is in the 20th percentile. Given the steepness in skew, calls may offer some of the most attractive ways to be brave in the US, while put spreads may offer the best value for those looking to hedge what is still a relatively mild pullback. Overall, our positioning would remain constructive.
Is there an exception? We would not ‘buy the dip’ in US credit, where my colleague Adam Richmond sees more risks, given weaker fundamentals, expensive pricing and limited upside in exchange for swimming against the recent tide.