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Equity 2014 Review and Outlook
Equity Derivatives Strategy
2
Executive Summary
Volatility across asset classes and in particular in Equity is being dragged down by a mixture of fundamentals and a change in the structural demand for investment products that seem durable and may force a general re-allocation to Equity – although looming risks remain
Credit Suisse Research Outlook for 2014 confirms this trend, with modest growth, low inflation and diminishing potential, good Equity prospects, but potential risks centered on spillover effects of Central Bank policies
Fed Tapering will be the main event for 2014, however we identify a few other dislocations that could disrupt the markets in the coming months: the return of leverage, Japan’s expansionary monetary policy, Bond/Equity and FX Equity re-correlation
Another Great Moderation in Equity?
4
The factors behind volatility compression
1Y Implied and Realised Volatilities – Global Equity Benchmarks
Source: Credit Suisse Equity Derivatives Strategy
The Great Moderation refers to the 2004/2006 period which saw sustained Equity performance along with record low volatility
Implied and realized volatility in global Equity markets have reached Great-Moderation lows, making Equity one of the best performing asset classes – Why?
2003 2005 2007 2009 2011 20130%
10%
20%
30%
40%
50%
60%Average 1Y Implied VolatilityAverage Realised
The conjunction of macro stabilization, good corporate earnings prospects and synchronized QE creates a bullish, volatility-suppressing environment
At the same time, record-low real yields force yield-starved investors to investigate alternative investments – often short volatility
5
0 50 100 150 200 25010%
15%
20%
25%
30%
35%
40%
45%
50%
Hist. Since 2004
"Last"
Macro are supportive of Credit and Equity
Macro stabilization in 2013:− Global growth of 2.9%, in line with 20Y average− Emerging Markets are the largest contributors to Growth
SX5E 1Y Implied Vol vs iTRAXX Europe
Source: Credit Suisse Equity Derivatives Strategy
Better corporate earnings prospects:− Record high margins− Sustained by lower
interest charges, wage growth, taxes, and better regional diversification of earnings
6
More QE and more synchronised QE
Low Central Bank balance sheet expansion in 2012 Synchronized QE in 2013:
− Fed: $85bn expansion in 2013 vs. $40bn in 2012
Excess Liquidity vs PE Expansion
Source: Credit Suisse Equity Research
− BoJ on track to double its balance sheet by 2014
− ECB under political pressure to do more
How Equity volatility is affected:− Excess liquidity supports
equity market valuations and lowers Equity Risk Premium
− Implicit Put on Equity reduces the need for hedges
7
The challenge of Yield Compression
Investors have preferred the perceived security of “safe assets” despite earning negative real yields, while assets considered riskier (Equity, Corporate Credit) are yielding above historical average on reduced risk
Lower yields pose an unprecedented challenge for the Investor:−Increases value of future liabilities−Decreases returns on hedging portfolios
Long-term US Real Yields
Investors are looking to either−Re-allocate to Equity −Allocate to alternative
investments (Smart Beta, Emerging Markets Bonds, Alternative Risk Premia)
8
Generate Yield through Alternative Risk Premia
Current low yield environment is not supportive for Equity participation products. Structured Product issuance has concentrated on yield products (e.g.: Auto-callables) which compress long-term vol and skew
30-Dec-04 01-J ul-07 30-Dec-09 30-J un-120.00
0.01
0.02
0.03
SX5E S&P N225
Source: Credit Suisse Locus
Institutions have continued developing their pure volatility activity with one additional objective: yield extraction, while regulatory news flow decreased the demand for long-term volatility
SX5E, S&P and Nikkei 5Y Skew
9
The “Smart Beta” Alternative: High Div Yield Smart Beta benchmarks are designed to provide superior
exposure to a given investment theme: for instance the EUROSTOXX Select Dividend 30 selects high yielding stocks and provides 5.5% div yield
Flows into High Dividend Yield funds have outpaced flows to all Equity funds since 2009
The performance of the High Dividend indices tends to be negatively correlated to government bond yieldsRelative Flow to Div Funds vs Equity
FundsS&P 500 Div Index Outperf vs 10Y Treas. Yield
Source: Credit Suisse Equity Research Source: Credit Suisse Equity Research
Volatility Supply and Demand in 2014
11
Institutions/Fundamental Long Shorts
General Outlook:− To heck with hedging after last
year’s 30% market rally and disappointing performance in 2012
− Levered Delta: Long Shorts outperformed thanks to low correlation; more single stock directional option trades
2014 Trading Implications:− Return of interest for European
underlyings given better outlook for European equities
− Potentially more interest for vol premium capture in the US given expected modest performance
Alpha Availability Index
Source: Credit Suisse Equity Derivatives Strategy
12
Volatility Hedge Funds
General Outlook:− Volatility Hedge Funds as a
group (HFRX) posted their second best year on record due to performance of opportunistic short vol
− Volatility long short strategies recorded a 2.5% loss for the year because of resilient vol of vol
2014 Trading Implications:− Dispersion (1Y correl at 60)
has become statistically unattractive
− Short Vol still interesting trade (SPX 1Y Var at 19.9 vs expected 11% realised)
VIX vs Subsequent 1M Realised Vol
Source: Credit Suisse Equity Derivatives Strategy
Cond. P&L of SPX Dispersion (100 vega)
Source: Credit Suisse Equity Derivatives Strategy
-60% -40% -20% 0% 20% 40% 60% 80%0%
10%
20%
30%
40%
50%
60%
% Change in NYSE Margin Debt
6M M
SCI
Wor
ld R
ealis
ed
Vol
13
Pension Funds
General Outlook:− Recent equity strength has
allowed funding shortfalls to narrow
− Interest rate increase in corporate segment and regulatory changes reduced the present value of liabilities
2014 Trading Implications:− Potential de-risking with
Equity markets at record highs− Little impact on equity
volatility as only 1% of pension plans actually hedge and typical put spread collar strategy has minimal vega impact
US Pension Funds Deficit
Source: Milliman
13
14
Structured Products (Retail)
General Outlook:− Issuance complicated by low
level of interest rates and low level of equity volatility
− Typical product embeds going short a DOI put option in exchange for an annual coupon with autocollable feature
2014 Trading Implications:− Depressed long term implie
volatilities and skews− SX5E dividend and repo
dislocation, as short long term forward exposure is hedged with long futures
Vega Profile of 1Y DOI SX5E Put (bar 2000)
Source: Credit Suisse Equity Derivatives Strategy
SX5E, S&P, Nikkei 5Y Skew
30-Dec-04 01-J ul-07 30-Dec-09 30-J un-120.00
0.01
0.02
0.03
SX5E S&P N225
Source: Credit Suisse Locus
Credit Suisse Global Outlook 2014
16
Key Points
Source: Credit Suisse Research
Global Growth 2014 Forecasts
Modest growth, low inflation and diminishing potential: the 2014 global economy looks to be the most orderly in many years on a stable triangle of.
Monetary policy in 2014 is likely to remain both highly stimulatory and highly innovative: the ECB could ease further through LTRO or negative deposit rate, BoJ could announce a 30% increase in the pace of monthly JGB purchase
Q1 Q2 Q3 Q4 12 13E 14E 15EGlobal Real GDP (q/q ann)3.6 3.4 3.8 4 3.1 2.9 3.7 3.9
Inflation (y/y) 3 3.3 3.1 3.4 3.1 2.8 3.2 3.5DM Real GDP (q/q ann)2.2 1.8 2.6 2.5 1.5 1.1 2.1 2.2
Inflation (y/y)1.1 1.5 1.6 1.9 1.9 1.3 1.5 1.9US Real GDP (q/q ann)2.5 2.7 3 3 2.8 1.7 2.6 2.8
Inflation (y/y)0.9 1.2 1.3 1.9 2.1 1.4 1.3 2.1Japan Real GDP (q/q ann)3.1 -1.2 3.5 2.3 2 1.8 2.2 1.2
Inflation (y/y)0.7 2.7 2.7 2.8 -0.1 0.3 2.2 1.7Euro zone Real GDP (q/q ann)1.2 1.3 1.6 1.7 -0.6 -0.4 1.3 1.7
Inflation (y/y)0.9 1.2 1 1.5 2.5 1.4 1.1 1.4UK Real GDP (q/q ann)2.3 3.1 3.1 3.3 0.2 1.4 2.8 2.5
Inflation (y/y)2.7 3 3 2.7 2.8 2.7 2.8 2.6EM Real GDP (q/q ann)5.2 5.2 5.2 5.6 4.9 4.7 5.3 5.7
Inflation (y/y) 5 5.2 4.9 5 4.3 4.4 4.9 5.1
2014E Annual Average
Fed Tapering: started in December (vs CS January Forecast) leading to rally in the dollar and higher rates
EM under pressure: narrower spread to EM in terms of economic growth, and the Fed tapering will cause more difficulties in EM FX markets.
17
Rates 2014 Outlook
The US as the driving force: the timing of Fed tapering, US growth, and inflation should be the key drivers for European yields.
US potential growth is expected to be higher than in Europe, and so US yields are expected to rise versus Europe
Rates Strategy 2014 Forecasts
Source: Credit Suisse Research
1Q 2014 2Q 2014 3Q 2014 4Q 2014Fed Funds Rate 0-0.25 0-0.25 0-0.25 0-0.25ECB Repo Rate 0.25 0.25 0.25 0.2510Y US Treasuries 2.9 3.05 3.25 3.3510Y German Bunds 1.75 1.85 1.95 2.110Y UK Gilts 2.9 2.95 3.05 3.15
18
FX 2014 Outlook
USD is likely to begin a multi-year rally as a result of be driven monetary policy divergences: Fed is likely to begin a gradual process of "normalizing" policy in January, while the ECB and the Bank of Japan remain focused on stemming the resurgent deflationary threat.
Yen and AUD are likely to fall the most against the dollar.
3m 12mEURUSD 1.3 1.28USDJPY 95 115GBPUSD 1.557 1.552EURGBP 0.835 0.825EURJPY 123.5 147.2USDCHF 0.946 0.953EURCHF 1.23 1.22
FX Strategy Forecasts
Source: Credit Suisse Research
"Twin-deficit" EM currencies are likely to experience episodic turbulence, as US monetary policy is gradually "normalized."
19
Equities 2014 Outlook
Forecasts: S&P500: 1960 (+8.5%), SX5E: 3600 (+16.4%), NKY: 18400 (+17.0%), FTSE: 7400 (+11.2%), MSCI EM: 1075 (+6.2%)
Equities are still cheap against bonds, even factoring in our bond team's forecasts
Excess liquidity related to monetary easing remains supportive for equities
Funds flow and long-term positioning still look supportive for equities: inflows into equity funds are close to an eight-month high, while bond funds are experiencing outflows
Margins appear set to stay higher than investors expect. Credit spreads appear set to remain tight, and credit marginally
leads equities. Realised Volatility Scenarios for 2014: SPX 11%, SX5E 16.6%
3 Investment Puzzles for 2014
21
The Return of Leverage in Financial Markets
Not a dislocation per se, but a potential magnifier of current market dislocations
Margin buying on NYSE is at all-time high, posting one of the fastest annual increases since 1985
High levels of margin debt are not per se a predictor of a market crash. However, high margin debt tends to accelerate market corrections
NYSE Margin Buying since 1985
Source: Credit Suisse Equity Derivatives Strategy1985 1989 1993 1997 2001 2005 2009 20130
100,000
200,000
300,000
400,000
Deleveraging versus Equity Realised Vol
Source: Credit Suisse Equity Derivatives Strategy
-60% -40% -20% 0% 20% 40% 60% 80%0%
10%
20%
30%
40%
50%
60%
% Change in NYSE Margin Debt
6M M
SCI
Wor
ld R
ealis
ed
Vol
22
The Japanese “Anomaly”
BoJ assets are expected to grow to 60% of GDP by end 2014 – double the size of the Fed, ECB and BoE, making Japan a disproportionate contributor to global liquidity after Fed tapers
BoJ expansion has managed to boost Japanese Growth, contributing 0.9% of 2.5% growth in 2013, and pushing the Nikkei up nearly 50% YTD
This was achieved at the cost of cross-asset volatility even larger than during the Fukushima incident compared to the rest of the world (3-sygma event)
Central Banks’ Expansion since 2007
Source: Credit Suisse Equity Derivatives Strategy
3M Realised Vol Ratio, Japan vs Other G3
Source: Credit Suisse Equity Derivatives Strategy
2000 2002 2004 2006 2008 2010 20120
0.5
1
1.5
2
2.5
3
3.5NKY/SPXJPYUSD/EURUSDJGB/Treasuries
23
FX/Equity Correlation
Typically, Equity/FX correlation is close to zero, or negative for most open economies (UK or Eurozone)
Since 2007, the financial crisis followed by Fed expansion, has led to a general Equity/USD negative correlation, leading to unusual correlation levels for other Equity/currency pairs.
This “new normal” has started breaking down in Q3, and traditional dynamics are expected to restore with the Fed Tapering in 2014, adding risk to European portfolios diversified with USD
FX/Equity Correlation since 2000
Source: Credit Suisse Equity Derivatives Strategy
FX/Equity Correlation YTD
Source: Credit Suisse Research
Oct Apr Oct Apr Oct Apr Oct Apr Oct-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
NKY/JPYSPX/JPYSX5E/EURFTSE/GBP
Mar Jun Sep Dec Mar Jun Sep
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
NKY/JPYSPX/JPYSX5E/EURFTSE/GBP
24
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