JPM's head quant Marko Kolanovic:
Volatility to Increase: In our comment last month, we argued that market volatility will increase. Volatility nearly doubled, rising from ~4.5% during the month of February to ~9% month to date. However, for volatility to cause de-risking by systematic investors, the increase needs to extend in time or magnitude (as these investors typically look back ~2-3 months rather than just 1 month). In terms of fund flows, this week there was some additional buying on account of the monthly option roll, and next week we could see this reverse and additional equity outflows given the MTD and QTD rebalances (e.g. see here). Our second concern surrounds the French elections next month. On our Global Markets conference in Paris last week, a survey of clients showed that only ~20% think that Le Pen may win (vs. 60% for Macron). Further complacency may set in in the aftermath of the Dutch elections yesterday, and US Equity markets (e.g. VIX) price virtually no event risk related to French election (in contrast to similar measures in Europe, see here). We maintain that the increase in volatility will continue (e.g. due to change in option gamma), and that there will be an increase of uncertainty related to French elections.
Near-term, market weakness is more likely than not. Clients have asked us ‘if everybody expects a correction, does that mean that it will not happen?’ Possibly, but our survey of clients last week shows that only 17% of them expect a correction.
Fed Put and Buying the Dip: Early this month, the Fed surprised the market by telegraphing a March hike. At the time, investors started speculating whether this was a sudden hawkish turn, or even a politically motivated decision. We think it might have been the move of a prudent monetary Dove. Hiking in March, gives the Fed the option to skip June should there be market turmoil (e.g. related to French elections). Indeed, the market-implied probability of a June hike dropped yesterday from 60% to 50%. After the dovish hike yesterday, extreme short positioning in bonds, and the selloff in rate sensitive assets (such as precious metals and REITs) snapped back. The short squeeze in these assets could have some momentum in the next several days. The dovish Fed outcome implies that the ‘Fed Put’ is likely still alive and well, so investors should buy on potential market weakness that we think could occur over the next month or so. This approach of buying on weakness is known as “BTD – Buy the Dip” (last two years virtually all of the market’s returns occurred one day after any the pullback i.e. ‘the Dip’). Success of the strategy is often attributed to the dovish resolve of central banks.
Trump Put: While the Fed put would disappear at higher rates, in less than a year the composition of Fed will be drastically different. In our report last month we pointed out that it likely means a Fed that has a higher tolerance for inflation, and favors a weaker USD and continuation of monetary accommodation. We think that it is a misconception that Republican nominees will be fiscally conservative (it is the party in opposition that becomes fiscally conservative). For more details on expected changes in the Fed composition see this note from our Economists. In addition to the Fed put, there is another driving force that can backstop a market selloff – we call it the ‘Trump Put’. Over the past weeks, the President has taken some pride and ownership in the rising US equity market. The market rally in the aftermath of the President’s address to Congress (March 1st), shows that it doesn’t take much to awaken the animal spirits of domestic investors. In the case of market weakness, there are a number of proposals and measures (such as Infrastructure, Deregulation, Tax Reform, Repatriation) that Trump could discuss and near-term back-stop the market. After all, assuming the full benefit of tax reform on 2018 earnings (see here) would justify the S&P 500 at meaningfully higher level than our current price target of 2400.