"Worst Case Scenario" Emerging: Morgan Stanley Warns "Selling Has Shifted"

Confirming JPMorgan's "worst case scenario" that forced de-levering in vol-based strategies would lead to retail ETF outflows and create a vicious cycle downwards, Morgan Stanley's Christopher Metli warns that today’s moves lower are likely not being driven by systematic supply – this appears to be more discretionary selling.

Risk-Parity funds are seeing some of the biggest losses in history...

But, as we previously detailedJPMorgan offered hope that this vicious circle of de-leveraging could be stalled - and had been in the past - by dip-buyers from greater-fool retail inflows.

In the past, just as we have seen this year, these risk-parity-correlation tantrums have been cushioned by equity market inflows, and we note that, in particular, YTD equity ETF flows have surpassed the $100bn mark, a record high pace.

If these equity ETF flows, which JPMorgan believes are largely driven by retail investors, start reversing, not only would the equity market retrench, but the resultant rise in bond-equity correlation would likely induce de-risking by risk parity funds and balanced mutual funds, magnifying the eventual equity market sell-off.

Which could be a problem...

As ETF outflows are surging...

And as Morgan Stanley's Christopher Metli - who previously explained what happens when VIX goes bananas - notes, today’s moves lower are likely not being driven by systematic supply – this appears to be more discretionary selling. 

Systematic supply from vol target strategies is largely out of the way now, while consensus trades are getting hit:  NDX is underperforming SPX, momentum is down 1%, and the Passive Factor is up, indicating actively held names are underperforming names better held by passive funds.

So why now, even though the systematic supply is largely out of the way? 

Well as noted in previous comments, consensus was that this was a dip to be bought and that vol should be sold.  While systematic funds delevered this week, there has been less discretionary supply and end users have bought very little protection. 

This makes the market still fragile to negative shocks – in aggregate less fragile than coming into the week for sure, but still at risk.

The shock today has been higher real rates on expectations of more Fed tightening to come.  After ignoring the original driver of this whole episode earlier in the week, investors have finally returned to the fact that the Fed is going to have to react to a stronger economy.  10y real rates today hit the highest since 2015 indicating tighter financial conditions, and breakevens are down slightly.

In some sense, Metli points out, these ups and downs are a normal reaction to the shock and pain of the Monday selloff, and as noted in previous comments the market usually remains choppy after these events.  A focus on rates and the upcoming CPI report on Tuesday, plus dealers remaining short gamma, likely means the market remains choppy for the next few days.

But Metli does offer some silver-lining hope - just as JPMorgan's Kolanovic did on Tuesday, another -4% SPX move is unlikely given lower systematic supply and less VIX ETP gamma, and the point of max pain is very likely behind us. 

Choppy means +/- 1 to 2% moves for a few days followed by a gradual moderation in volatility as the market digests a more hawkish Fed.

...unless the bond market becomes truly unhinged, he adds.

Finally, Metli notes that right now, the options market does not fully price in a higher volatility environment for longer, and the inverted curve means forward volatility is relatively inexpensive.

June VIX futures are only in the 35th 10-year percentile, while even further out volatility between June and Dec of 2018 is only in the ~10th 10-year percentile – good value versus a VIX that is in the 90th percentile.

Comments

new game A Sentinel Feb 8, 2018 6:20 PM Permalink

lower highs and lower lows, until higher highs and higher lows.

we will never see an 08-9 again as the banksters, shysters and corrupt congress and senate learned that letting the free markets do what it is going to do could harm themselves bigly. as in: gone, bankrupt, jobless, loose everything. it will never ever happen(again), hence a china style manipulated market for a long long tyme...

In reply to by A Sentinel

Neighbour lloll Feb 8, 2018 7:29 PM Permalink

"Still, no politicians are addressing America's Real problems."

Wait till the rest of the world deals with our problems, ie: Foreign investment morale in USA, unethical economic regulations, currency manipulation and trade wars!

 

Bottom line llol- shut-out of world markets because a new one has taken over.

Swift(ly) will come down, reserve currency status "Kaput".

 

 

In reply to by lloll

Baron von Bud oddjob Feb 8, 2018 7:09 PM Permalink

Fact is, the stock market could go much higher before it goes down. Rising tbond rates won't affect stocks much until they hit 4.5%. At that point the Fed Model kicks in and investors watch the compared earnings yield and bond yield. Lots of room and time here for disciplined money to play the yield gap both ways.

In reply to by oddjob

new game idontcare Feb 8, 2018 7:11 PM Permalink

18k is NOT gone, loose everything, looking for a job. do you not recall 08-09? afer lehman everything was going to the shitter. goldman sacks would be gone. wells, indy, citi, usbank. fuking gone. complete reset. didn't happen did it? down 18k would all ok and fine and doing the usual for these fuks...so we agree? lol...

In reply to by idontcare

hannah new game Feb 8, 2018 7:40 PM Permalink

wrong...the banks did die in 08-09. the lid was closing on the casket and the fed reserve stuck their fingers inand stopped it. doesnt mean the banks arent dead. you dont create a quadrillion dollars of fake bad financial shit and jst walk away. the whole fiat system is dead. printing trillion wont save it or bring it back to life.....

In reply to by new game

Endgame Napoleon natronic Feb 8, 2018 7:33 PM Permalink

They are keeping this crash out of the news, with that latest abuse scandal preoccupying the MSM. Most of Trump’s voters are much more concerned about any backdown on illegal immigration, but I can empathize with people who lose a lot. Frankly, it looks like the stocks go up and down, so unless they are needing to cash it out, they’ll probably recoup a lot of their losses over time. The day traders on here have to make their money much quicker. I guess they have a lot more risk. People who invest in the the day trading probably know the risks and are looking for higher returns. 

In reply to by natronic

Endgame Napoleon gatorengineer Feb 8, 2018 7:38 PM Permalink

No. The jobs are still mostly part time, temporary, high turnover and 1099 gigs. Rent still consumes more than half of monthly, earned-only income. The Uniparty Swamp is kicking most of us in that situation in the head, allocating a Fake Tax Cut that will add a ton to the deficit, while financing a Costco membership for most of us. Meanwhile, they loaded on doubled child-tax-credit welfare for part-time workers with kids. Their maximum refundable child tax credit was already at $6,444, and they are the ones who are eligible for multiple layers of monthly welfare, not all of us getting the $24-per-paycheck Fake Tax Cut. 

In reply to by gatorengineer

MusicIsYou Feb 8, 2018 5:40 PM Permalink

They aren't acquiring millions of ounces of silver for no reason. Silver is actually better than gold because silver is usually a byproduct and seldom discovered in pure mass quantities. 

Dewey Cheatum … Feb 8, 2018 5:42 PM Permalink

It's finally great to see all of these so called market geniuses get a face full of reality, when their bullshit synthetic portfolios, get a margin call...while everyone rushes to liquidity...and there is none. 

been waiting a long time, to see just how deep their pockets really are.

Hopefully worth the wait.