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The storm at the centre of the calm

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Good morning. Yesterday morning’s letter opined that “This is a scary moment, but it does not look like the edge of an abyss”. Well, Ethan and I felt like morons by lunchtime, and geniuses when teatime rolled around. We had emphasised the fact that the extremes of the sell-off were contained to the riskiest parts of the market; that the economic backdrop remained solid and could improve if the virus loosed its grip; and that the Fed might yet move at a deliberate pace, rather than slamming the brakes. But as the S&P 500 hit a 4 per cent decline, and the sell-off ripped into stocks of all flavours, we started to wonder if we had been paying attention to the right stuff.

By the close, the market was in the green. What’s going on? Email us your theories: robert.armstrong@ft.com and ethan.wu@ft.com.

Markets are calmer than they seem

Of course we can’t make sense of extreme intraday volatility, because it is not required to make sense at all. But there is something to be said about the wider context and — without presuming to know what today will bring — help explain why the market caught a bid yesterday afternoon.

One key piece of context is the calm that has prevailed in fixed income markets even as fear took hold of equities. Here is the sell-off in the S&P over the past month, compared with an index of the very riskiest corporate bond spreads. As the sell-off accelerated, risky bonds yield gap over treasures widened moderately — to end about where it was a month ago.

I asked Marty Fridson, of Lehmann Livian Fridson, about junk bonds’ relative calm. He said:

It seems to suggest that the inflation premium is growing, and higher discount rates are being applied [to stocks]. That is different from saying the economy is collapsing. There doesn’t seem to be a concern about earnings, but rather about valuations. It’s not an economic issue that would cause [bonds’] default premium to rise . . . there is always the possibility of a Fed mistake [hitting the economy] but that’s not where the market is at 

Turning to another corner of the market, I asked Jenn Thomas of Loomis Sayles, who covers asset-backed securities, whether that market has felt any reverberations from the equity sell-off.

ABS have not missed a beat, she said. She describes the pricing of consumer ABS — backed by auto loans, credit card receivable, personal loans, and so on — as stable to the point of being range bound in recent weeks. Three new issues (in subprime auto, prime auto, and personal loans) priced yesterday, as the equity market was roller-coastering, and all were oversubscribed. The $40m triple B tranche of the consumer loan ABS, yielding 4.4 per cent, was oversubscribed by a factor of nearly five. “Demand is so heavy”, she said.

Thomas noted that, after a long hiatus created by stimulus checks and supplemental unemployment benefits, “typical subprime behaviour” is starting to return in the lowest-rated securities. A modest increase has occurred in early-stage delinquencies. But it is not affecting investor demand.

Commodities are likewise unbothered. Copper and aluminium have roughly traded sideways for weeks. Gold may even be benefiting from the sell-off in crypto (see below) as investors wanting a hedge look elsewhere. Brent crude was bumped down about 2 per cent by some of Monday’s tumult, but David Martin, commodities strategy head at BNP Paribas, offered this bullish read:

The outperformance of Brent against other markets, e.g. European equities, speaks to the fundamental support that the tight physical market conditions offer at the current juncture. Arguably, the fact that Brent spreads have held up so well, in face of a 2 per cent decline in flat price, signals continued strength in the prompt [ie, short-term] market.

Finally, the options market is not expressing particular panic, either. We asked Benn Eifert, who runs QVR Advisors, a volatility and derivative hedge fund, about what equity derivative markets are telling us about the cash equities market. We spoke before the market bounced at mid-day yesterday. He said:

For the last few weeks in December you had a lot of fast institutional money de-levering [options positions], pushing net leverage down a lot, and gross leverage down too. There was lots of put buying at the end of the year [for downside protection]. 

When we get into January, [stocks] are selling off, with tech and software selling off the most, there was not much response [in the options market] because people were not over of their skis. People had already de-risked …

Now we’ve had a pretty big peak to trough drawdown, and options liquidity does strange things in markets like this … but this is not something that is being driven by a particular [big trade unwinding].

It’s really retail that is super long, and all the data shows that retail is trying to buy the dip. It feels like you won’t see fireworks, because you don’t have people being liquidated out of huge positions. Fast money institutions are usually what cause big crashes.

The sane positioning of the big institutional money doesn’t mean the market can’t fall a lot more in a slow grind, Eifert pointed out. It just means a wild pattern of self-reinforcing selling is not likely.

Summing up, then, it still looks like what we have is a relatively contained sell-off in equities, rather than a generalised flight from risk. Investors are acting jumpy, but not indiscriminately so. And within equities — to overgeneralise somewhat — the sell-off is focused on the kinds of things that have done well for much of the last decade, and especially well in the last two years. That is not simply speculative tech stocks. Indeed, the pattern may be best visible in the performance of US stocks (the great winners of the last 10 years) against stocks in the rest of the world over the past three months. Chart from Refinitiv:

The most extreme example of recent winners returning to sanity is probably crypto, where total market cap has been cut in half in just two months. The moves in bitcoin — one of the less volatile cryptocurrencies in recent days — have increasingly followed equities, building to a bitcoin-S&P correlation spike on Monday as dip-buyers swooped in (data from Koyfin via CoinDesk):

Evidence of a durable relationship does not exist here. S&P rallies don’t consistently accompany bitcoin run-ups. But since the pandemic, it sure looks like bitcoin speculators are prone to sell when stocks get ugly. But bitcoin has bounced back from deep troughs before. (Armstrong & Wu)

One good read

Gideon Rachman on western Europe’s “navel gazing” in the face of Russia’s threats.

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