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Global Equity Volatility Insights
Want a cheap call on EU equity? Monetise
correlation through EU bank dispersion
we estimate 68% of the
20 June 2017
Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com
US
Extract alpha from summer SPX range as policy and positioning “collar” equities
With the Federal Reserve last week appearing more emboldened to normalize monetary
policy, risk asset bears have come out in force. While we agree that a changing Fed
reaction function is likely not supportive of substantial equity upside, we think the
“Yellen put” still exists, albeit with a lower strike. Hence, we see monetary policy as
providing a near-term “collar” (long put/short call) on a US equity market already prone
to getting trapped in record-tight trading ranges. Further impetus for a summer rangetrade
should come from (i) fiscal policy, as gridlock caps equity upside but policy hope
floors the downside, and (ii) positioning, where the risk of continued “fragility events”
(potentially exacerbated by stretched quant fund/short vol positioning) meets cashed-up
investors still accustomed to buying dips. As a risk-limited range trade, we like buying
in-the-money down and out puts on the S&P. For example, an SPX Sep 2475 put that
knocks out at 2300 (6% OTM) indicatively costs 70bps (spot ref 2451), a 60% discount
to the 2475 / 2300 put spread.
Europe
Long EU banks dispersion: Buy Dec17 call on a basket, sell worst-of call
We recommend positioning for greater dispersion in EU bank sector returns via buying a
Dec17 105% call on an equally-weighted basket of Santander, BNP, ING, Intesa and
Deutsche Bank, part-financed by selling a worst-of call on the same basket for 1.8%
(net) indic., as: 1) improving macro/earnings, sensitivity to rates and regulatory
headwinds are likely to lead to greater differentiation within banks, 2) the entry point is
attractive given historically low implied vol (13 th 8y+ percentile) and high implied
correlation (81% bid vs latest 6M realised correl of 66%), 3) historical risk-reward at
current pricing is attractive (avg. P&L of +8.4% when positive vs -1.8% when negative),
and 4) the trade can be considered as a cheap call on EU equities as it has a similar
payoff profile but with greater benefit relative to its cost.
Asia
Buy depressed China vs. US risks through corridor variance spreads
As global central banks have taken on more hawkish tones, the uncertainty surrounding
policy tightening will be more positive for EM volatility than for DM volatility.
Additionally, our strategists have a more bearish outlook for the Chinese banking sector
(which makes up a majority of the HSCEI index) amid rapidly rising leverage, complex
shadow banking, and excessive home price inflation. Since we believe the global
synchronized monetary tightening will impact HSCEI volatility more than SPX volatility,
we recommend owning HSCEI-SPX 70/110% corridor variance at 5 vol points, a 3 vol
point discount to a vanilla variance spread. The entry point is attractive as the HSCEI-
SPX 18-month variance swap spread has fallen back to the lower-end of its 5-year
trading range, the trade has a positive carry, and it benefits during China risk-off events.
>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under
the FINRA rules.
Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take
responsibility for this report in particular jurisdictions.
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making
their investment decision.
Refer to important disclosures on page 28 to 29. Analyst Certification on page 27. 11756528
Timestamp: 20 June 2017 01:18AM EDT
Equity Derivatives
Global
Global Equity Derivatives Rsch
MLPF&S
Anshul Gupta >>
Equity-Linked Analyst
MLI (UK)
Nitin Saksena
Equity-Linked Analyst
MLPF&S
William Chan, CFA >>
Equity-Linked Analyst
Merrill Lynch (Hong Kong)
Abhinandan Deb >>
Equity-Linked Analyst
MLI (UK)
Benjamin Bowler
Equity-Linked Analyst
MLPF&S
benjamin.bowler@baml.com
Jason Galazidis >>
Equity-Linked Analyst
MLI (UK)
Clovis Couasnon >>
Equity-Linked Analyst
MLI (UK)
Chintan Kotecha
Equity-Linked Analyst
MLPF&S
Michael Youngworth
Equity-Linked Analyst
MLPF&S
Nikolay Angeloff
Equity-Linked Analyst
MLPF&S
See Team Page for List of Analysts
Table 1: 3M volatility (weekly changes)
Implied Realized
S&P500 9.8 (-0.2) 7.1 (-0.2)
ESTX50 13.4 (0.3) 11.5 (0.2)
FTSE 10.0 (-0.4) 9.7 (0.2)
DAX 12.6 (0.3) 10.7 (0.5)
NKY 13.8 (-0.2) 12.3 (-0.2)
HSI 12.4 (0.1) 10.1 (0.2)
KOSPI 12.2 (0.3) 10.5 (0.1)
EEM US 15.6 (0.5) 11.8 (-1.1)
TOP40 16.9 (1.2) 11.1 (0.3)
RDX 25.9 (0.9) 20.6 (-1.1)
IBOV 22.9 (-1.7) 25.5 (-0.7)
ISE30 20.2 (0.4) 13.5 (0.1)
Source: BofA Merrill Lynch Global Research
BofAML GFSI TM X-Asset Risk Landscape
Stress now below normal for all asset classes
The indicator was little changed last week, finishing at -0.23.
• Stress is now in benign territory across all five asset classes: Stress in
across all asset classes (except equity) declined last week. Notably, rates stress
turned negative (benign territory) and stresses across all five asset classes are
now negative.
• Stress in Equity skew rose as ESTX50 and (to a lesser extent) S&P500 skew
steepened; indeed the gain in ESTX50 skew was the greatest across GFSI subcomponents
(Chart 2) and also historically significant (Chart 5).
• Commodity-related stresses fell the most across asset classes (Chart 3), led
by declines in Crude and Gold vol (Chart 2), reversing some of the gains after
geopolitical tensions in the Middle East rose in recent weeks.
Chart 1: Latest* stress across GFSI sub-components
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
GFSI Stress
1.48
1.39
Govt-OIS EUR
Basis Swap USDJPY
1.00
0.81
Basis Swap EURUSD
Euro member Bond…
0.54
Nikkei Skew
Red shaded area highlights components in
Bearish territory
ESTX50 Skew
Bond Basis EUR
Govt-OIS USD
HY Bond Flow
Source: BofA Merrill Lynch Global Research. *Latest as of 16-Jun-17.
Risk
Skew
Flow
Green shaded area highlights components in
Bullish territory
-1.17
-1.18
-1.24
-1.38
-1.45
CDS Index Skew USD
CDS Index Skew EUR
USDJPY Skew
Bond Basis USD
Libor-OIS USD
Equity Fund Flow EM
SP500 Skew
IG Foreign Sovrn Bond…
Libor-OIS GBP
GBPUSD Imp Vol
Libor-OIS JPY
EURJPY Skew
Sub IG Foreign Sovrn…
Libor-OIS EUR
HY Corp CDS USD
IG Corp CDS USD
IG Corp CDS EUR
Comdty Imp Vol Crude
Volume Flow
HY Corp CDS EUR
AUDJPY Skew
HSI Imp Vol
USDJPY Imp Vol
FTSE Imp Vol
Money Mkt Flow
ESTX50 Imp Vol
Comdty Imp Vol Copper
SP500 Imp Vol
3Y/5Y Credit Curve EUR
Int Rate Imp Vol USD
Comdty Imp Vol Gold
Nikkei Imp Vol
EURUSD Imp Vol
Int Rate Imp Vol EUR
Chart 2: Change** in stress across GFSI sub-components
0.8
Change in GFSI Stress
0.4
0.0
-0.4
-0.8
0.65
ESTX50 Skew
0.21
CDS Index Skew EUR
0.12
0.10
SP500 Skew
GBPUSD Imp Vol
0.07
Libor-OIS USD
Source: BofA Merrill Lynch Global Research. **Latest as of 16-Jun-17. Change vs 1 week prior (9-Jun-17).
The GFSI Risk Allocator (using Bull, Bear & Neutral weights of 2, 0, 1) suggested a 17.4%
overweight position on 16-Jun (vs 13.0% OW as of 9-Jun). The percentages of Bullish,
Bearish and Neutral GFSI components (as used in the Risk Allocator) as of 16-Jun were
34.8%, 17.4% and 47.8% respectively.
-0.20
-0.23
-0.23
-0.37
-0.38
Govt-OIS USD
Govt-OIS EUR
ESTX50 Imp Vol
Equity Fund Flow EM
HY Corp CDS USD
Bond Basis USD
Sub IG Foreign Sovrn…
IG Corp CDS USD
HSI Imp Vol
Nikkei Skew
USDJPY Imp Vol
Libor-OIS JPY
Libor-OIS EUR
Money Mkt Flow
HY Corp CDS EUR
IG Foreign Sovrn Bond…
HY Bond Flow
Libor-OIS GBP
SP500 Imp Vol
Nikkei Imp Vol
IG Corp CDS EUR
3Y/5Y Credit Curve EUR
EURJPY Skew
FTSE Imp Vol
Int Rate Imp Vol USD
Comdty Imp Vol Copper
Int Rate Imp Vol EUR
Euro member Bond…
EURUSD Imp Vol
CDS Index Skew USD
Basis Swap EURUSD
Basis Swap USDJPY
Comdty Imp Vol Gold
AUDJPY Skew
Comdty Imp Vol Crude
USDJPY Skew
Bond Basis EUR
Volume Flow
Risk
Skew
Flow
2 Global Equity Volatility Insights | 20 June 2017
Chart 3: Stress in commodities fell the most last week (driven by a drop
in crude oil vol) while stress in equities rose marginally (led by equity
skew)
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
0.04
-0.03 -0.03 -0.08
-0.16
Equities Credit Rates FX Commodities
Chart 4: EM and the US are the least stressed GFSI regions globally
0.05
0.00
-0.05
-0.10
-0.15
-0.20
-0.25
-0.30
-0.35
-0.40
0.02
0.02
-0.01 -0.03
EM Europe Japan US
Latest stress (16-Jun-17)
Change in stress
Latest stress (16-Jun-17)
Change in stress
Source: BofA Merrill Lynch Global Research. 1wk change (9-Jun-17 to 16-Jun-17).
Source: BofA Merrill Lynch Global Research. 1wk change (9-Jun-17 to 16-Jun-17).
Chart 5: Top 10 movers in stress (1-week abs chg %-ile vs history*)
%-ile of abs chg in stress vs history*
100%
90%
80%
70%
60%
50%
92%
ESTX50 Skew
83% 82% 82% 81% 80% 79% 79% 77%
Libor-OIS USD
USDJPY Skew
Bond Basis EUR
Basis Swap
EURUSD
Comdty Imp Vol
Gold
Basis Swap
USDJPY
67%
Source: BofA Merrill Lynch Global Research. * %-ile of weekly move in stress vs all historical weekly
moves (earliest 3-Jan-00). Bar colours represent rise (red) or fall (green) in stress. 1wk change (9-Jun-
17 to 16-Jun-17).
AUDJPY Skew
Stress fall
Stress rise
Euro member
Bond Spread
Comdty Imp Vol
Crude
Chart 6: Global volatility & credit spread stress in the GFSI
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
-1.2
-1.4
0.01 0.01
HY CDS
Latest stress (16-Jun-17)
FX Vol
IG CDS
0.00 -0.01 -0.02 -0.06
Equity Vol
Change in stress
Sovrn risk
Source: BofA Merrill Lynch Global Research. 1wk change (9-Jun-17 to 16-Jun-17).
Rates Vol
-0.16
Commodity Vol
Global Equity Volatility Insights | 20 June 2017 3
Volatility in the US
Risk-limited alpha in a “collared” market: SPX ITM KO puts
US equities vulnerable…to a summer range-trade
The Federal Reserve last week appeared more emboldened to normalize monetary
policy, not only raising interest rates by 25bps but also reiterating its intention to hike
four more times by the end of 2018 and stating that it “expects to begin implementing
a balance sheet normalization program this year” - all despite recent softness in
inflation data. Breakeven rates of inflation narrowed following the Fed communications
due to tighter monetary conditions in the face of slowing US economic data, and risk
asset bears responded in force, suggesting that Janet Yellen had “broken up” with
investors and that it would be prudent to sell “before it’s too late”.
We agree that the changing reaction function of the Fed is likely not supportive of
further substantial US equity upside and may be viewed as the Fed now providing a
short call option on the S&P 500. However, in our view, it is premature to conclude
from last week’s developments that the “Yellen put” is dead. We see its strike as
declining but would not underestimate Yellen’s dovish inclinations in a shock or the
capacity for the Fed to still remain credibly on hold as long as the US economy is not
“running hot”.
In short, we see monetary policy as now providing a “collar” (long put / short call) on a
US equity market that has already shown a propensity over the past year for getting
trapped in record tight trading ranges. 1 Other factors may also conspire to create a
summer range-trade for US equities, namely (i) fiscal policy, where gridlock likely caps
equity upside but lingering policy hope floors the downside, and (ii) positioning, where
the risk of continued “fragility events” (potentially exacerbated by stretched quant
fund/short vol positioning) meets cashed-up investors still accustomed to buying dips.
Tug of war between fragile market/stretched positioning and cashed-up dip-buyers
As we have noted recently, US equities have displayed a historically unusual tendency to
jump rapidly from calm to stress and back (“fragility”), with the recent Tech sell-off and
rebound the latest example. For example, in the past year, the S&P 500 has seen
5sigma declines (3 in total—Brexit, Sep-16, May-17) occur 20x more frequently than
over the prior 90 years or so. The increased frequency of these “fragility events” is in
part due to vol failing to remain high post a spike as equity market participants continue
to aggressively “buy the dip” and in the process reset vol lower.
Historically low vol alongside consistently upward trending equity markets and low cross
asset correlations could be creating stretched positioning across markets. For example,
upward trending equities on historically low vol may be pushing CTA equity positioning
to near record levels (Chart 7). Risk parity portfolios could be increasing their leverage
due to low vol as well as low cross asset correlation (Chart 8). And lastly, inverse VIX
ETPs have seen increased open interest as performance has swelled on the back of
continued declines in vol and attractive term structure risk premia (Chart 9).
Should vol spike again alongside a reversal in equity price momentum and a rise in cross
asset correlations, then unwinds from these strategies could exacerbate market fragility.
However, this must be weighed against an investor base that has plenty of cash on hand
(Chart 10) and their potentially fickle but still-intact tendency to view any equity market
dip as an alpha opportunity.
1
For example, the Dow Jones Industrial Average traded in its tightest trading range in over
110 years in Jan-17; this followed a record in the S&P 500 ending Sep-16 for the longest
stretch of trading within a range of 1.77% since 1928.
4 Global Equity Volatility Insights | 20 June 2017
Chart 7: A combination of upward trending global equity markets and
very low volatility have conspired to push trend following (CTA) equity
positioning to near record levels. Consequently, the beta of CTA
strategies to global equities is also at extreme levels
Chart 8: Owing to low cross asset vol and strong diversification, the
volatility of risk-balanced multi-asset portfolios has fallen to historically
low levels. Consequently, leverage levels across multi-asset & other
portfolios that target fixed vol have likely hit their caps
1.00
0.75
0.50
0.25
0.00
-0.25
-0.50
-0.75
-1.00
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
Jan-17
Mar-17
MSCI World (Ratio of trend strength to volatility) (LHS)
BofAML Model CTA Global Equity Allocation (RHS)
May-17
20
15
10
5
0
-5
-10
-15
-20
24%
20%
16%
12%
8%
4%
0%
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
Model Risk Parity Leverage (Vol Target: 10% & Max Leverage: 3x) (RHS)
Unlevered BofAML Model Risk Parity Volatility (LHS)
3.0x
2.5x
2.0x
1.5x
1.0x
0.5x
0.0x
Source: BofA Merrill Lynch Global Research. Based on daily data form 2-Jan-2015 to 16-Jun-2017.
CTA = Commodity Trading Advisor
It is important to note that not all CTA, risk parity, or vol control strategies operate
similarly and there is model risk in estimating the exact size of these trading flows.
Source: BofA Merrill Lynch Global Research. Based on daily data from 3-Jan-72 through 16-Jun-17.
Equity, fixed income, and commodity components within the hypothetical risk parity investment are
represented by the S&P500, 10-Year US Treasury Bonds, and the S&P GSCI Index, respectively. Risk
parity allocations are determined and rebalanced monthly using prior 12-month realized volatility
and correlations.
Chart 9: The vega outstanding in inverse VIX ETNs has also reached a
record high at ~$125mn vega
Chart 10: Global FMS average cash balances (%) remain elevated,
suggesting dry powder for investors still conditioned to buy equity dips
VIX ETP open interest ($mn vega)
350
Unlevered long
Levered long
300
Inverse
Net vega across VIX ETPs
250
200
150
100
50