Complacent Investors Run Risk of Reliving ‘Parable of the Boiling Frog’
They are not worried.
Published: Dec. 2, 2017, at 12:16 p.m. ET
Markets ‘unwilling or unable to perceive gathering threats’: SocGen
Is it getting warm in here?
Analysts at Société Générale think it is, and they’re worried that investors won’t notice until it’s too late. In a Tuesday note, they laid out their fear that investors are in danger of “reliving the parable of the boiling frog.”
That’s the dusty trope that holds that a frog in a pot of water sitting on a stove will remain content as the temperature slowly rises, not realizing its soon to be boiled alive until too late.
In SocGen’s telling, investors are in the role of the frog, participating in markets that “for now are unwilling or unable to perceive the gathering threats.”
Meanwhile, investors content with low interest rates, abundant liquidity, stable growth and a focus on the positive aspects of U.S. President Donald Trump’s agenda continue to push asset prices, volatility and leverage to historical extremes, they said, warning that a low volatility carry environment “with rather extreme positioning” is a dangerous combo. Carry refers to the ability to hold offsetting positions, in which one offers an incoming cash flow that is greater than the obligations of the other.
While historically low readings for the CBOE Volatility Index VIX, -3.17%, a measure of expected volatility for the benchmark S&P 500 index SPX, +0.27% amid the run by U.S. equities to record after record has garnered substantial attention, the SocGen analysts note that volatility is low across several asset classes — something they don’t expect to last. As the Federal Reserve continues to raise interest rates, the VIX will inevitably begin to rise, “with contagion effects across asset classes,” they said.
Meanwhile, other major central banks are likely to follow the Fed’s lead and reduce the size of their balance sheets next year, they said, putting upward pressure on sovereign bond yields, especially at the back end of the curve (they expect the 10-year U.S. Treasury yield TMUBMUSD10Y, 0.665% to rise to 2.80% by the third quarter). As U.S. Treasury yields normalize, the competitive advantage enjoyed by U.S. equities will start to fade, they said.
The SocGen analysts also home in on hedge-fund positioning, noting an annual exercise in which they look at net positions to identify assets with “extreme positioning.” They define extreme positioning as a net position one standard deviation or more above or below the historical average. In January 2017, 54% of hedge funds’ net positioning across assets could be considered extreme (a level that is now at 54.2%).
The main culprits are bets on a falling VIX, a position that has delivered tremendous return since 2016, U.S. 5-year Treasury’s TMUBMUSD05Y, 0.273%, crude oil US:CLF8, and copper US:HGF8. Positioning hasn’t been so extreme since January 2007—a few months before the onset of the global financial crisis, they noted.
In addition, falling correlation within assets—in equities, this has been seen as a boon for long suffering stock pickers—are also worth worrying about, they said. Here is the danger:
The low correlation is good as of now, as it brings some diversification benefit within a multi-asset portfolio—for example, the decorrelation between EM and global equity markets observed last quarter persists and partly justifies our 7% allocation within the multi-asset portfolio, alongside the supportive growth, yield and US dollar outlooks. However, it also gives a false sense of security, as the correlation regime can quickly reverse in case of risk-off events in the markets and exacerbate a market selloff.
So, what is a froggy to do? The SocGen analysts say they are not waiting around in the pot. They have further cut their equity exposure to 40% from 50% and are now overweight government bonds, with 28% exposure versus 18% last quarter.