In light of today's euphoric market reaction, which has seen the VIX plunge by over 3 vols, or 20% lower, to just over 12 and sent both the Nasdaq and S&P higher by 1% on relief that there were no mushroom clouds of the weekend, the jury is out whether last week's sharp risk off, short-vol mauling will persist or be just another BTFD opportunity. But while last week's tension may already be forgotten, some disturbing trends persist. As SocGen's Andrew Lapthorne writes, while the S&P trades near all time highs, the smaller cap Russell 2000 dropped a much sharper 2.7%, leaving this index up just 1.3% for the year and down 5% over the last couple of weeks on what we discussed last week was a growing concern for the US economy and companies who do not have exposure to international revenue.
Furthermore, High Yield Credit also fell sharply. Along with the Russell 2000, HYG has also unwound most of this year’s positive performance in a matter of weeks. As Lapthorne writes, "in our view, high yield credit and the Russell 2000 are all the same trade with different wrappers. Their continued success is highly dependent on asset volatility remaining as subdued and debt markets as generous as they have been, both of which we think is highly unlikely."
But the most interesting observation made by the SocGen strategist in his overnight report is that the sudden aversion to balance sheet risk is not restricted to US small caps or HYG, "indeed within the S&P 500 ex financials such a strategy remains the most profitable of our US investment styles this year."
"What might be contributing to this performance trend", Lapthorne asks rhetorically? Here is the most likely explanation: "share buybacks have slumped by over 20% YoY." Ominously, this is the sharpest drop in corporate buybacks since the financial crisis effectively shut down bond markets in 2008, as a result of the market no longer rewarding companies that lever up just to repurchase their own stock.
SocGen's conclusion: "Perhaps over-leveraged US companies have finally reached a limit on being able to borrow simply to support their own shares." If so, this is a big problem because as Credit Suisse showed recently, corporate buybacks have been the only source of equity injection since the crisis.
If this phase is now officially over, it is unclear what - if any - new source of capital inflows, central banks notwithstanding, will replace corporations as the main buyers of US equities going forward.