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Investment Outlook 02.2018
TOPICS
EDITORIAL
Thomas Trauth
Economist, Dr. rer. pol., CFA, FRMEquity market correction and volatility spike
Equity market correction and volatility spike
After a strong rally of risky assets at the beginning of the year, we saw a worrying sell-off, starting on 26 January. Developed equity markets, were up 7% until 26 January and since then have lost about the same amount. Emerging markets equities gained roughly 10% and lost 7.5% thereafter.
The salient question is whether this is the beginning of a major market correction or a short-term sell-off which will not change the positive outlook for 2018.
In order to answer that question, we have investigated the cause of the sell-off. At the end of January, it became apparent that inflation, which remained surprisingly subdued in 2017, is set to increase. This became especially clear when the US labor market report of 2 February revealed that average hourly earnings had risen 2.9% in January, the largest increase since 2009. This sparked fears of rising inflation and faster monetary tightening by central banks. As a result, equity markets lost and bond yields climbed.
The magnitude of the sell-off was puzzling, however, but can be explained by the certain developments.
Implied volatility, the price of options to insure against market losses, rose significantly (Fig. 3). Many hedge funds have profited from falling volatility levels, which resulted in elevated positions in so-called inverse volatility strategies. Those hedge funds incurred heavy losses when implied volatility spiked recently. Losses from such trading can be illustrated by Fig. 4, which shows the loss incurred by a Credit Suisse product which gives exposure to the inverse of the volatility. In order to exit their positions in the volatility trade, hedge funds had to sell equities to hedge out their option positions. On top of that, there is evidence that funds, pursuing quantitative trend following strategies, acted as additional sellers when markets were already falling, amplifying the sell-off.
To summarize, while the macro environment is certainly changing as inflation finally returns, the recent market crash can partly be explained by technical factors. This suggests that the market correction will be rather short-lived and looks exaggerated. Therefore, we today cautiously added some equity exposure.
Nevertheless, we expect that central banks will normalize their monetary policy faster than expected, which will bring back more volatility to markets. In our view, this should not change the still positive outlook for equity markets in general.