MACQUARIE: Here's how to protect against 'grotesquely swollen financial markets' that will go haywire this year

  • Cross-asset measures of volatility have been at historically low levels for months.
  • The role of global central banks has been shifted in recent months as they have become mostly concerned with keeping this volatility subdued, says Macquarie.
  • Eventually, price swings will rock the market, and investors would be well-served to buy volatility in preparation for that.

Traders, strategists, and market experts at large have for months lamented the lack of price swings in global markets.

Volatility across all asset classes has been subdued for most of the past year, and it’s created what many view as an unsustainable situation marked by investor greed and complacency.

That’s essentially shifted the role of global governing bodies into bystander mode, according to Viktor Shvets, Macquarie’s head of global equity strategy, who doesn’t mince words when addressing the issue.

“Central banks and financial supervisory bodies have essentially morphed from masters of the universe into slaves of grotesquely swollen financial markets,” he wrote in a recent client note. “In this surreal world of complete dominance of financial assets, conventional economic rules break down and financialization and avoidance of sharp asset price contractions becomes the paramount policy objective.”

This chart showcases just how placid financial markets have become. This combination of factors is untenable to Shvets, who forecasts a massive uptick in volatility – one he sees many investors as ill-prepared to handle.

1 29 18 financial stress index COTDMacquarie ResearchAn index of financial stress maintained by the St. Louis Fed is at one of its most placid levels ever.

At the core of Shvets view – and also a key part of why he anticipates an eventual volatility storm – is the idea that central banks are now beholden to markets, rather than the other way around. He notes a “well-imbedded investor belief that central banks would not allow volatilities to destroy their carefully constructed fa├žade.”

“It is this investor confidence in the inability and unwillingness of central banks to tolerate volatility of asset prices that explains why financial conditions globally and in the US continue to ease, even as central banks have become increasingly hawkish,” said Shvets.

Volatility will soon be beckoning, however, as these same central banks grow increasingly frustrated that their usual policy transmission channels are blocked, he argues. Shvets sees them continuing to raise the cost of capital, which could in turn result in a potentially harmful over-tightening by China.

“This can easily lead to a sudden jump in volatilities,” he said. “No matter what happens, volatility is likely to materially jump at some point in 2018.”

So what’s an investor to do, assume they can shake off creeping complacency? Shvets recommends buying exposure to volatility, something that’s easy to do through means exchange-traded products tracking the Cboe Volatility Index – or VIX.

It might seem like a counterintuitive trade, considering the VIX has been locked near record low levels for much of the past year. But it’s the right call in the face of an impending spike in price swings, according to Shvets.

There’s a “possibility of potentially very strong dislocation,” he said. “Buying volatility and protection could yield significant returns.”

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