11.08.17

Snapshots’ paternity leave has been delayed by a few days. Thankfully it has nothing to do with escalating tensions with North Korea but is due to spinning babies and the Left Occiput Anterior

Fire and Fury

The recent market rally stopped in its tracks and reversed quite sharply this week.  The reversal coincided with Tuesday’s comments by President Trump on further aggression from North Korea being met with “Fire and Fury”.  Also, Disney ended its distribution deal with Netflix which caused a pause in the perpetual business model assumption of the FAANGS stocks, which are the darlings of the current bull market.  We also note that market liquidity is low due to annual leave and valuations in the liquid markets have been high for some time.

It was interesting to see that the current sell-off was led by equities which we commented on (and expected) very recently.  Currently market betas are behaving as we would expect in the liquid markets and government bonds are rallying.

Inverse VIX and Accelerators

Gillian Tett at the FT joined the chorus of big investors expressing caution yesterday.  In an editorial she talked about the rise of ETFs and in particular “inverse ETFs” which sell volatility.  She states that one of these inverse ETFs is the 34th most actively traded equity security this year.  Peter Tchir at Brean Capital is an ex-credit trader who has made it his life mission to map and understand the growing ETF market.  He notes that these inverse ETF securities have “Acceleration Event” or “Termination Event” triggers which can cause forced unwinds of the short volatility position embedded in these ETFs.  Also, the leverage embedded in these structures means that losses above the NAV of the funds could be borne by the ETF provider or by the counterparty on the other side of the underlying trades.

To those old enough to remember, these triggers sounds like the GAP risk that was embedded in structured credit transactions in the run up to the GFC.  The good news is that the market cap of the two biggest inverse ETFs is approximately $1.3bn meaning forced unwinds should be manageable.  However, it is yet another idiosyncratic risk we need to be aware of.

Our playbook has been for rising Q4 risks and volatility in the liquid markets.  We still think these are pricing and volatility risks as opposed to credit cycle/recession risks.  The transmission mechanism from price to credit cycle would be if the capital markets suddenly withdrew liquidity as a result of a price crash.  We will continue to watch all of these factors closely.

By Asif Godall
Deputy CIO