One way to assess how much pain looms for global stocks post-Brexit is to figure out who needs to sell. Strategists analysing fund flows say that includes computer traders, exchange-traded funds and individuals who piled into European stocks expecting a different outcome.
Britain’s departure from the European Union will unleash as much as $300bn of selling by automated quant programmes in the already-battered US stock market, according to Marko Kolanovic, the JPMorgan Chase & Co derivatives strategist. His colleague Nikolaos Panigirtzoglou looked at ETF and government data and concluded that US investors own a lot more European stock than they did during the sovereign debt crisis four years ago.
Equity investors in the US would be wise to stay away until quant managers finish the work that was forced on them by Friday’s volatility, Kolanovic wrote on Friday. About $2.6tn was erased from global share markets and the CBOE’s volatility index shot up 49% on Friday as investors worried Brexit would snarl commerce and snuff out the economic recovery.
“The volatility that we’re seeing now is winding and unwinding of positions that were set up in expectation of a ‘Remain’ vote,” said Walter “Bucky” Hellwig, who helps manage $17bn as senior vice president at BB&T Wealth Management in Birmingham, Alabama. “Volatility has been introduced here because of the unexpected results. It caught the market by surprise.”
The S&P 500 Index dropped 3.6% on Friday, capping a five-day decline of 1.6%, as more than 15bn shares traded across US exchanges, double the daily average so far this year. MSCI’s global stock index plunged 4.8% in the biggest slide since August 2011, while European stocks slid 7% in the worst day since 2008.
Leveraged ETFs tied to the S&P 500 created additional downward momentum in US equities on Friday, as fund owners sold more shares as part of their daily rebalancing, according to Panigirtzoglou. The mechanical process that amplifies returns caused more than $4bn in forced selling on Friday, the most since August, he wrote.
Kolanovic is one of several Wall Street quant gurus predicting elevated selling in the wake of the UK decision, after UBS Group’s Rebecca Cheong predicted on Friday as much as $150bn in automated sales.
Kolanovic previously warned that low realized volatility and high leverage among funds was a potentially toxic combination as the decision in Britain loomed.
Both are derivatives analysts who generally try to predict how automated funds will react to volatility and other market inputs. One of their assumptions is that as levels of turbulence fluctuate in US equities, it triggers robotic decisions in programmes that buy and sell stocks to keep portfolio volatility around preset targets.
The vote will “serve as a catalyst for higher volatility and deleveraging of systematic investors,” Kolanovic, head of global quantitative and derivatives strategy at JPMorgan, wrote in a note to clients on Friday. “The equity outflows from systematic strategies will likely be comparable to the August 2015 and January 2016 selloffs.”
Quant trading accounted for $25bn of selling on Friday, the result of investors hedging short positions, according to the note.
While that would normally be about 10% of the total value of stocks traded in any given day in the US, on Friday it was less than 5%, data compiled by Bloomberg show. An additional $100bn in automated sales will hit over the next few days, with $40bn coming from volatility targeting, $40bn from trend-following strategies and as much as $30bn from risk parity funds, which try to balance exposure across asset classes, according to Kolanovic. The sales could end up totalling closer to $300bn, depending on how realised volatility responds to recent stock market shocks, his note said.
Panigirtzoglou compared the stock holdings of professional and individual investors now versus the 2010-2012 sovereign debt crisis, when European shares fell as much as 26% and the S&P 500 narrowly avoided a bear market. He calculated that non- bank entities currently own about $49tn of equities, compared with $47tn of cash and $27tn of bonds.
“That is, non-bank entities, which invest in both bonds and equities, have an allocation to equities that is close to 40% currently of their combined cash/bond/equity holdings,” he wrote. “This is around three percentage points above the average level seen during the 2010-2012 euro debt crisis. On our calculations it would require another 10% decline in global equity indices from here, for the equity weighting of non-bank investors in the world to return to euro debt crisis levels in a worst case scenario.”
In an attempt to gauge how far American investors were leaning toward Europe prior to the Brexit vote, his team also examined government balance-of-payment data and the relative size of US-listed ETFs that own European stocks. Both methods suggested positions that were well above those of 2010-2012.
“Admittedly that period was characterised by an acute sovereign debt crisis which triggered a banking crisis in Europe, something that has low probability of happening in the current conjuncture,” he wrote. “As such, investor positioning during the euro debt crisis can be thought of as the worst case for markets in the current conjuncture, in a very adverse scenario where Brexit ends up causing a lot of economic disturbance in terms of trade, people and financial flows as well as business confidence in Europe.”
Kolanovic sees the S&P 500 as having one leg up on the August sell-off, when the index fell 11% to a 10-month low while facing similar behaviour from algorithmic traders: there’s much more stock market liquidity. That’s partially a result of the rebalancing in Russell indexes, an annual process that fuels equity market volume.
While equity turbulence is unlikely to turn into a long- term ordeal, investors will need to be prepared for the worst.
“As the selling eventually abates in a few weeks, investors will need to reassess the probability of a US recession,” Kolanovic wrote. “In the absence of decisive monetary or fiscal measures, we see the probability of a recession increase significantly.”
Traders work on the floor of the New York Stock Exchange. The S&P 500 Index dropped 3.6% on Friday, capping a five-day decline of 1.6%, as more than 15bn shares traded across US exchanges, double the daily average so far this year.
