Odd Market Correlations Lead To Kolanovic Market Concerns

Correlations are looking odd, the JPMorgan quantitative and derivatives researcher Marko Kolanovic observed in a February 16 strategy note to clients. The only known human to predict a flash crash says market correlations will return and in doing so might usher in volatility. On the populist contagion that has many in Europe concerned, Kolanovic says not to worry. In the long run it will work out. It is maintaining the status quo where real problems arise.

Kolanovic: Election shock resulted in volatility and then market price dislocations

The US presidential election was a shock on many levels. From a market perspective, Kolanovic notes the “violent re-pricing” of stocks and other assets.

Kolanovic, who predicted a rise to 2300 in the S&P 500 in the wake of Trump’s election, now looks at the stock market and notes a significant sector and style rotation that occurred, with money rushing into banks and out of interest-rate sensitive utilities.

The collapse of correlations is “temporary,” as volatility events often are. The price dislocations were “driven by violent re-pricing of market segments in relationship to recent macro developments,” he wrote. While the Trump victory created a rotation, strong seasonal effects momentarily pushed correlations lower. “In a turn of the year effect, investors rotated from e.g. large to small, momentum to value, etc. which pushes correlation lower,” he wrote.

Given that the average volatility of individual stocks and sectors has been remarkably stable (at ~20%, and 13% respectively), an increase of correlations would drive market volatility higher. Correlations will likely increase from these levels, which will likely push short term S&P 500 realized volatility up to ~4% higher (i.e. from 6% to 10%, assuming single stock volatility stays constant at ~20% and correlations increase from ~15% to 35%).

Kolanovic notes that an increase in volatility would result in a “meaningful de-leveraging” of risk parity and volatility targeting strategies. Markets could witness near 50 billion in stock market outflows from volatility targeting strategies, as much as $30 billion coming out of risk parity strategies with increased levels of volatility. In fact, volatility could lead to more market loses. The resultant market reaction means “a significant risk … is building up.”

In addition, if the overhang of market makers’ long gamma positions wears off, this his could add an additional ~2% volatility points (for this to materialize investors would need to add / roll protection higher, or the market would need to slide lower by 1-2%). Indeed, many investors watched the past few days how the S&P 500 was squeezed higher, and there was frenzied buying of upside call options. This was not as much a bullish sign, but in part caused by closing of large option positions that were supplying upside S&P 500 volatility and gamma (mentioned in our August report). As was the case with other systematic strategies (volatility targeting, CTAs, etc.), low market volatility forced investors to increase leverage in short volatility systematic strategies as well (which results in either selling more options, or selling riskier, closer to the money options, leading to potential accidents).

Kolanovic: The real risk in Europe is not addressing the core problems

There has been much discussed regarding political risk lately, with the rise of populism evident in Brexit and the Trump election concerning to investors.

Kolanovic, for his part, thinks populism is a “release valve” and the real damage will be done by not addressing the core issues:

We are of the view that political changes in Europe are inevitable and reflect an expected popular reaction to two persistent pressure points: 1) a common currency that is too strong for less developed European economies (which some see as ‘gutting out’ the periphery), and 2) demographic and social tensions that are related to recent waves of immigration (e.g. the majority of Europeans would support an immigration ban even more radical than the one proposed by Trump). These pressures will continue to boost left and right populism, respectively. Once these issues are addressed in a substantial and constructive manner, tail risk in Europe will decrease (rather than increase). Populist victories (e.g. as was the case in Brexit and the US election) in that sense may act as a release valve for tensions, stabilizing the system long-term. The alternative of keeping the status quo or entrenching in ‘irreversible’ positions on matters such as political or currency unions, geopolitical commitments and partnerships, etc. long-term destabilizes the system and can lead to more radical and disruptive changes.

While US President Donald Trump is a populist and has an opportunity to influence change, perhaps the most significant moves can be found from the perspective of the US Federal Reserve.

Marko Kolanovic notes Trump will be appointing a new Fed chair as well as other board members, including the individual responsible for regulating the banks. The nominees are expected “to have similar views on market critical issues such as the value of the dollar, fiscal expansion and debt.” Trump’s appointments may lead to “a higher tolerance for inflation, weaker USD, and continuation of monetary accommodation,” with Kolanovic advising investors to plan accordingly.