Macro: Sandcastle economics
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Warning brief: market sell-off risks may be at highest since pandemic outbreak.
John J. Hardy
Head of FX Strategy
Summary: We are at the end of the post-pandemic policy cycle and this brings with it the potential for a period of significant transitional volatility. This article is an abridged set of points looking at the evidence that the broader market is at risk of rolling over significantly in coming days and weeks and what investors can do to generally risk market exposure.
Note: this is an abridged version of a far longer article – see the original article for more background, charts and additional charts.
What: this market is set up for a potentially very significant correction (baseline of 10-20% given the magnitude of the recent draw-up) in the coming weeks as the post-pandemic policy cycle is coming to an end and already reversed for some countries. We may be early and /or wrong, but a cascade of developments and forward concerns have us on edge here. Please keep in mind that this article is meant to provide some food for thought rather than serve as a recommendation for action.
Evidence
- The Fed is pulling away the punch-bowl in coming months and has signaled as such recently in its clear indication that a tapering of asset purchase is on its was before year ahead, barring a mishap in the economy on the delta variant, etc.
- Markets have started rolling over even before the Fed is set to pull out, with the bubbliest stocks as seen in our Saxo Bubble Stocks equity theme basket rolling over from their remarkable peak already in February, US long yields rolling over starting in Q2, copper and crude oil breaking down after highs in May and early July, respectively, suggesting forward concern for growth.
- In FX, the US dollar is responding to the Fed’s shift and is poised near the highest levels of the year and AUDJPY, a classic proxy of all things pro-cyclical, has likewise broken down
- Risk measures are picking up to the largest degree this year, as noted in our Saxo Global Risk indicator
Ways to reduce risk
- Simply reducing leverage to avoid compounding possible downside risk.
- For longer term and general inspiration, consider an all-weather, 100-year portfolio, as discussed by our Steen Jakobsen (Note that Chapter 8 discusses the portfolio principles).
- Besides simply a partial reduction of exposure to the market, some may consider
- Options hedges (long puts) in the S&P 500 and/or the Nasdaq 100 futures, which are very liquid markets. The tough part here is choosing strike prices and expiry dates
- Hedging the market using a volatility ETF like the VIXM (ProShares VIX Mid-Term volatility ETF). The reason for using the mid-curve as opposed to products more sensitive to spot volatility is that it “costs less“ in terms of negative carry to hold the position, even if it is potentially less reactive tactically to moves in volatility.
In any case, be careful out there.
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