Escalating systemic risk: BREXIT & more

We’ve observed a classic escalation of systemic risk last week, culminating in Friday’s European Equities led plunge, as several Brexit polls showed “Leave” in the lead. While UK is currently at the periphery of the global equity network, contagion spread throughout Europe and global equities as seen in Fig. 1 below.

Fig. 1. Global Equities FNA Correlations Outlier Ranking 10 Jun 2016

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Risk continued to escalate into this week, as Asian markets continued a negative cascade. Particularly worrying is was the 15 to 22 VIX spike from Friday to Monday, the biggest two day moves since last year’s August Flash Crash. Investors will do well holding on to safe haven assets like US Government Bonds and JPY. Not to mention Bitcoin, which has reached new two year highs and looks like an increasingly attractive asset class. The video below illustrated key risk dynamics.

Brexit Systemic Risk Escalation Video

Weak US Growth Sparks Global Rally

The S&P 500 reached a new 10 month high on Wednesday, in a global rally sparked by last Friday’s disappointing jobs report that showed the US added only 38,000 new jobs, its weakest showing since 2010. That’s right. Weak US growth led to a global asset rally because it took June Fed hikes off the cards. Not what one would call a convincing sustainable rally. As we can see in Fig 1 below, USD Index was the top cross asset outlier with a -3sd plunge, while just about everything else rose.

Fig. 1. Cross asset FNA Correlations 8 June 2016

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USD continues to be a major systemic pressure point, and broadly negatively correlated against most major assets. A weaker USD takes off pressure from China, which flows into broad global relief.

Below is a short video focusing on key pressure points and market dynamics using FNA’s cross asset dashboard.

Video 1. Weak 3 June US jobs report sparks global asset rally (3:11 min)

 

 

Another Fed Taper Tantrum?

Global markets tremors continue to escalate on Wednesday as bonds and rate sensitive sectors plunged after the Fed revealed it was open to June rate hikes. Marketwatch posed the critical question: Could this post-Fed bond selloff be a repeat of ‘taper tantrum’ which saw 10 year Treasury yields jump 140 basis points in 4 months?

Our cross asset FNA Correlations map in Fig 1 ranks Wednesday’s top surprises, with Corporate Bonds and EMBI plunging by over 2.7σ. Given key tail risks global investors are increasingly worried about, credit sensitive assets are especially vulnerable. Furthermore, emerging markets and commodities could quickly give up recent gains with continued USD strength.

Fig. 1. Cross asset FNA Correlations map ranking outliers on 18 May.

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US government bonds remain most reliable global safe haven asset

Although US government bonds fared poorly on Wednesday, their insurance value makes them valuable safe haven assets for global investors. US government bond to equity correlation remains reliably elevated at -.7 (strongest link to Financials indicated by red link). Fig. 2 ranks most impacted assets by a -3σ predictive Brexit + China shock, and highlights US 10 & 20+ year government bonds as positive outliers (with VIX)

Fig. 2. Predictive -3σ Brexit & China shock on cross asset FNA Correlations map

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Top global investor tail risks: Brexit & China

Be prepared for “a summer of shocks,” noted a recent Bank of America Merrill Lynch global investor survey. A ranking of tail risk shows Brexit in first place, followed closely by China devaluation/defaults.

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Indeed, as noted in Emerging Risks & Safe Havens we’ve seen escalating tremors in global markets since Bank of Japan’s 28 April global markets surprise.

Below is a short video where we use our cross asset FNA Correlations map to run predictive Brexit and China stress tests. The most resilient assets for each scenario: USD & US Government Bonds.

Video 1: Brexit & China Stress Test (4:22 min)

Thank you for tuning in, and feel free to suggest emerging risk themes to analyze.

 

 

 

Emerging Risk & Safe Havens

Yesterday’s cross asset FNA Correlations map revealed a classic flight to safety to US Government bonds. Global market tremors have escalated since Bank of Japan shocked markets last week by announcing no additional stimulus. The left panel on Fig. 1 ranks cross asset class 95% Confidence Level Value-at-Risk (VaR) outliers. Emerging Markets $EEM were yesterday’s top surprise with a -2.2sd plunge, followed by CAD and European equities. Chinese large caps $FXI declined as China’s PMI disappointment led to a third day of falling commodities.

Fig. 1. Cross Asset FNA Correlations 3 May outlier ranking 

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It’s worth focusing on Emerging Markets, which saw its first negative surprise since 3 Feb as volatility edged up from 100 day lows. As Fig. 2 illustrates, surprises in Emerging Markets tend cluster, so expect more volatility going forward.

Fig. 2. Emerging Markets surprises tend to cluster: get ready for turbulence

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Asset Allocation To Diversifying Safe Havens

As Emerging Market volatility jumps from 100 day lows, expect contagion to broader risk assets, especially oil, commodities, EMBI, junk bonds, financials and developed market equities. Asset allocation to safe havens will be critical to minimize portfolio volatility and drawdowns.

The short video below analyzes the most effective safe haven assets given the market’s correlation structure, focusing especially on JPY, US Government Bonds, TIPS and Gold.

Video 1: Most Reliable Flight To Safety Assets

Thank you for tuning in. Please feel free to suggest additional market themes and emerging risks to explore at alan@fna.fi.

Bank of Japan Surprises Global Markets

Illustrating once again how dependent global markets are on central bank liquidity, global markets tumbled into Risk Off mode after Bank of Japan (BOJ) Governor Kuroda offered no additional stimulus measures on April 28.  JPY jumped by an exceptional 3.2σ vs USD as Japanese equities plunged by 2.8σ, taking global equities into the red. DJIA experienced its first negative outlier since 20 Jan, showing the extent of global contagion. Fig 1. shows a ranking of cross asset outliers on 28 April, which resembles a classic flight to safety pattern (negative equity outliers & positive Gold outlier).

Fig. 1. Cross Asset FNA Correlations ranking of top outliers on 28 April

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Seatbelt time again?

On Friday, JPY rose to an 18 month high vs USD, Gold experienced another positive outlier to reach a multi-year high, and global equities bled. Global markets are getting nervous again. Although volatility declined on Monday (VIX below 15 again) as equities bounced, investors should not be surprised to see increased market volatility given significant systemic risk. A jump in global equity volatility would continue to favor JPY, as well as VIXUS 20Y+ Government Bonds and Gold. These Flight To Safety Assets have shown the most consistent negative correlation to equities (red links) throughout 2016.

Japan equity predictive stress test

Japanese equities look especially vulnerable, given lack of BOJ support. In Fig 2 below we simulate at -3σ MSCI Japan predictive stress test, ranking most affected assets on the left panel. JPY and VIX Futures are the most effective insurance, while Gold and US government bonds & TIPS also show significant appreciation.

Fig. 2. -3σ MSCI Japan predictive stress test on Cross Asset FNA Correlations

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We discuss the dynamics of last week’s BOJ surprise in Video 1 below.

Video 1: Systemic implications of JPY surge & flight to safety (4:25 min).

 

 

Weaker USD key to global asset rebound

As discussed in USD as a Systemic Pressure Point, a weaker USD has helped catalyze a global asset rebound. A Bloomberg News’s headline today reads: “Weaker Dollar Sparks Commodities Rally; U.S. Stocks Edge Higher.”A weaker USD takes pressure of Emerging Markets, especially China and commodities producers. In Fig. 1 below we show the negative correlation of the USD Index against most global assets (red links), and simulate a -3σ shock of USD and highlight biggest beneficiaries. The top time series shows that even European equities correlation turned significantly negative against USD in march.

Fig. 1 Cross Asset FNA Correlations -3σ USD predictive stress test

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While the broad USD Index trend is down, we have started to observe some negative outliers in EUR and CHF vs USD recently. Yesterday CHF/USD surprised for second time outlier since 12 April.

Fig. 2 FNA Correlations highlighting CHF/USD negative outlier (95% Confidence Level)

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It’s worth monitoring continued developments in the FX landscape as a key driver of behind the global asset rebound. Central bankers around the world are likely to encourage a gradually weakening USD for the time being, especially against Emerging Markets currencies.

 

Oil Plunge impact on global markets

Oil futures plunged by as much as 6.8% this morning after producers failed to come to an agreement in Doha to limit supplies . Oil’s positive correlation with global equities has been a persistent drag on markets, and indeed Asian equities and global stock futures have started the week in negative territory.

Fig 1. shows the predicted impact of a -3σ (8.7%) plunge in oil using the Cross Asset FNA Correlations map. This shock is broadly negative to global risk assets, and red highlighted assets are most affected (with losses exceeding 95% confidence level VaR). The stress test also shows that US 20+yr government bonds would likely be the preferred safe haven asset (green highlight), with a gain of 1.2%.

Fig. 1. Oil predictive stress test using Cross Asset FNA Correlations 

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In this short video we explore the systemic impact of an oil plunge on global assets, using the Cross Asset FNA Correlations monitor.

Video 1. Analyzing oil’s systemic impact on global markets (3.13 min) 

Global Banks Lifted with improved China trade data

Last week’s top surprise was the global banks rally, apparently driven by improved Chinese trade data on April 13, highlighting the continued importance of China to global markets. This synchronized global bank rally comes at a cost, however: 70% systematic risk (i.e., volatility driven by a common market factor), which exceeds last year’s Aug Flash Crash levels. Fig. 1 shows systematic risk reaching a new 100 day high on April 13, with green highlighted banks representing positive daily outlier returns (95% Confidence Level).

Fig. 1 GSIB FNA Correlations map highlighting 95% confidence level VaR outliers on April 13Untitled 3

Fig 2. below shows the Cross Asset FNA Correlations on April 13, ranking China large cap equities $FXI as top positive outlier, followed by Financials $XLF. CHF and EUR surprised to the downside vs. USD (red highlight) in a broad risk market rally.

Fig. 2 Cross asset FNA Correlations ranking of outliers on April 13

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China’s improved trade data was clearly a big relief to banks and markets globally, but elevated systematic risk suggest caution. High systemic coupling implies that any surprises — such as a renewed oil plunge or a downside Chinese surprise– could result in a synchronized plunge.

The short video below briefly reviews the key dynamics driving the global bank rebound, with a special focus on the increased correlation between Chinese and global banks.

Video 1: Analyzing the Global Bank Bounce of April 13 (2.53 min)

 

USD as a systemic pressure point

As discussed in last week’s Implications of a weaker USD, we started to observe USD early warning signals since Dec 3 2015 and again in March. Most importantly, the correlation matrix of USD Index ($UUP) against major assets has turned broadly negative, suggesting that global markets would benefit from a gradually weakening USD. Pimco’s head of European FX Thomas Kressin agrees: “The dollar’s three-year advance is coming to an end as central banks recognize a strong U.S. currency is not in the interests of the global economy” (8 April, Bloomberg.com). He further noted that The Fed “is willing to let inflation overshoot the 2 percent target,” not wanting to fall into Japan’s deflationary negative rate spiral. Indeed we alerted that US TIPS were the biggest positive surprise in our analysis of the March 16 Fed Rake Hike Delay decision, suggesting that increased inflation risk is starting to be priced into US markets.

Last week’s cross asset FNA Correlations confirmed a continued weakening USD trend with correlated global rebound. Fig. 1 below shows a series of new 100 day USD Index lows with declining volatility (left) and negative correlation (red links) to all major asset classes which broadly rebounded (green = positive return).

Fig. 1. 8 April Cross Asset FNA Correlations: USD Index negative correlation vs global assets

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Thank you for visiting, and feel free to suggest any themes for discussion.