REDEFINING DERIVATIVE SOLUTIONS FOR SEDATED MARKETSConference insights

Societe Generale and Risk Derivatives Conference 2019

October 2019

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Societe Generale & Risk Derivatives Conference 2019

Contents

Challenges ahead for investors in sedated markets ............................................................................................................................ 2

Politicans must heal a fractured UK society ............................................................................................................................................................. 3

Search for alpha in a volatile world ............................................................................................................................................................................................. 5

Europe eyes the pitfalls of Japanification ...................................................................................................................................................................... 7

Redefining derivative solutions for sedated markets

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Derivatives strategies are more relevant than ever in today’s “sedated” markets, declared Jean-François Grégoire, head of global markets at Societe Generale, opening the SocGen/Risk.net derivatives conference in London on October 4.

The amount of negative-yielding government bonds in the world  – €15 trillion of them  – was “mind-boggling,” he said. Volatility is structurally low, yield is compressed, regulators are continuing to put pressure on both the buy- and sell-side, as well as Brexit and trade wars – all impacting markets. Using the words of SocGen’s ‘permabear’ global strategist Albert Edwards, Grégoire said: “We are definitively in the ice age of financial markets.”

He continued: “To address these challenges, we think derivatives solutions are relevant and the right tool to help overcome these difficulties and generate alpha.”

With $28 trillion of assets under management represented in the room, the conference was geared to enlighten participants on how daily users of derivatives can adapt in markets and generate performance.

It is a challenging time to be an investor or indeed a bank, noted Duncan Wood, global editorial director at Risk.net, who was chair for the conference.

In previous years, the event has focused on where and how to generate returns using derivatives-based strategies. While that emphasis continues, and looking at fixed income as an example, where a large proportion of the world’s bonds promise to yield less than nothing over their lifetimes, there are three responses that can be made, all of which involve a difficult trade-off.

“Traditional bond portfolio managers can chase yield by travelling down the credit yield curve at the cost of increased default risk. They can play around with term structure, which obviously requires longer durations and increases rate sensitivities to maintain their returns. Or they can transition to alternative, less liquid structures,” said Wood.

Throughout the day, workshops focused on these ideas as well as looking at when and how to run a business, and how to strategise more efficiently while seeking alpha. ■

Challenges ahead for investors in sedated markets If we are in the ‘ice age’ of financial markets, can derivative strategies begin the ‘big thaw’?

Jean-François Grégoire, Societe Generale

Duncan Wood, Risk.net

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Societe Generale & Risk Derivatives Conference 2019

The UK is heading for a calamity “significantly worse” than the financial crisis, according to journalist Robert Peston. While the “mess we are in today” can be laid to some extent at the foot of the economic and financial shocks of the 2007–08 financial crisis  – including the impact on living standards – he believes there is a more fundamental problem underlying the nation’s dithering over Brexit.

“We have messed with the confidence people have in the way we run Britain, with judges and democratic institutions: this is Humpty Dumpty falling off the wall. You break confidence in the basic infrastructure of the country and it’s difficult to put it together again,” declared Peston in his keynote address to the conference.

For Peston, the “Brexit mess” is the result of underlying problems in the UK. The majority of economically underprivileged people, the unemployed and those living in social and council housing voted to leave the European Union, despite evidence they would be poorer by leaving.

“These people saw the Brexit campaign as a proxy for all the bad things that had happened to them and a reaction to a country that was not being run in their interests,” he said. “We are living through the longest period of stagnating living standards and productivity since the early 19th century. We will not get back to the living standards before the financial crisis until well into the next decade.”

At the same time, the technological revolution is aggravating the perceived unfairness of the way the country is run. Online companies such as Google and Facebook have made their founders fortunes over a short period of time, but are perceived as not playing by the rules, by not paying taxes at a rate that most domestic institutions – and people – pay.

Simultaneously, there is a feeling the UK is run in the best interests of those who are already wealthy. There is an absence of a credible fiscal policy with the government handing over responsibility to the Bank of England. The UK, however, is not alone in this tactic.

“We are at the end of the central banks’ ability to stimulate the economy with zero-bound rates. We have undermined the ability

of banks to create stimulus,” said Peston, pointing to the deliberately inflated asset prices that have done little beyond widening the gap between rich and poor.

Despite the anxiety many feel about the possibility of a Labour government led by Jeremy Corbyn, that party has put its collective finger on what went wrong and has a plan on how to fix it, at least in part, suggested Peston.

An analysis of the worst-served areas of the country, where basic social institutions such as community centres, libraries, youth clubs, swimming pools and basic transport have been undermined or closed, reveals that these areas almost completely match those that voted to leave the EU.

This near-correlation of Brexit support to places where communities feel the most abandoned is where the Labour party wants to concentrate efforts. Some of its ideas are strong enough to have cut through the Brexit rhetoric, advocating “perfectly rational policies” aimed at improving the worst-hit communities.

The policies are nothing to do with being in or out of the EU. The country, according to the Labour party, needs schools that are fit for a world of robotics, not geared towards turning children into robots. It believes there is something fundamentally wrong when a great number of people in full-time employment find themselves forced to rely on food banks.

As Britain tears itself apart over when, how or even if it leaves the EU, the data shows conclusively that leaving will have negative economic effects. For example, the gap between what investment levels should be and what they actually are is widening at an accelerated pace. The trend began immediately after the vote to leave the EU.

The country is already poorer. The lack of investment is undermining the UK’s ability to create wealth and fix underlying social problems, driving the further fracturing of society.

Together with the significant problems facing Britain  – environmental concerns, an ageing population, the need to improve healthcare and pensions – is the propensity of social media to drive people apart. “To a large extent, social media is undermining our ability as a nation to forge a common purpose,” said Peston.

Politicians must heal a fractured UK society Political journalist Robert Peston has grave concerns over the future of Britain, seeing profound risks with or without Brexit

Robert Peston

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He sees people arguing not on the basis of empirical evidence. Rather, they are saying evidence is serving some “elitist cause” and “alternative” truth is the norm. “This is dangerous stuff,” he says.

Fuelling this social media backlash are leading politicians on both sides of the Atlantic. The UK prime minister Boris Johnson and US president Donald Trump are doing things differently from the way politicians have done things in the past, using Twitter and inflammatory language to stir up millions of discontented middle- and lower-income citizens.

“The way [Johnson] is tapping into this discontent is dangerous. He is describing the institutions and individuals who people them as the ‘enemy’. They have been successful in driving a wedge between the people and democratic institutions,” he says. “This is an even more dangerous road to go down than Brexit, fracturing the very basic infrastructure of what makes Britain successful: confidence in the rule of law and democratic institutions. It is undermining in a damaging way our ability to prosper.”

As an example of this technique, Peston uses the recent UK Supreme Court ruling that the prorogation (suspension) of parliament by the government for five weeks was illegal. Through his contacts, he has heard some people at the centre of government describing the 11 judges that made the unanimous ruling as elitist “remainers” trying to frustrate Brexit.

“This is nuts,” declared Peston. The judges made a rational decision based on a sensible rational assessment of where the power in Britain’s political structure lies. While there was no precedent, the principle that sovereignty lies with parliament and not the executive was the basis of the judgment, explained Peston.

But when politicians deliberately distort the truth and rational decisions, trouble will follow, he predicted.

“Johnson is someone who admires much of what Trump has done in connecting with a particular audience, using language that most recoil from. In economic terms, he’s a trip back to the 1970s,when there were no fiscal constraints and rules, almost like the French president putting huge faith in infrastructure projects. He wants to be a big spender and is desperate to appeal to Labour working-class voters who went for Brexit. His priorities are spending on the health service, policing and schools.”

If, however, at the next election, Labour were to take control, it would preside over the “greatest transfer of power and income from capital to labour in history”, according to Peston. One of the most dangerous policies for the City of London and financial services in particular is the Labour party’s intention of imposing a financial transaction tax. That, believes Peston, would shift business away from London.

Whatever the final result of Brexit  – and the next general election – Peston believes a “terrible anger” against established politicians will continue. This rage is doing significant damage to politics and the nation.

Many in Britain bought into Brexit on the basis that it would be a way to “take back control” and make the country stronger. “However, there is a genuine risk that Brexit will lead to the break-up of the UK. There is increasing pressure in Scotland to be independent and momentum for a vote to unify Northern Ireland with the Republic of Ireland. The stakes are incredibly high,” concluded Peston. ■

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Societe Generale & Risk Derivatives Conference 2019

Volatility spikes are becoming more frequent but are also short-lived. Over the last four or five years, investors have become used to them. With the prevalence of risk premia and volatility-selling strategies that dominate the front-end of the vol curve, many see these spikes as an opportunity to buy underlying assets, said Will Bartlett, chief executive officer at US-based Parallax Volatility Advisers in a panel at the Societe Generale/Risk.net derivatives conference.

Looking at implied volatility on most products in the 30-day or less time frame, investors consistently trade under realised. Putting this gamma onto the books of firms such as Parallax that are natural hedgers has tended to make the suppression of volatility a “somewhat self-fulling prophesy where we buy straddles; effectively, the sellers don’t hedge them. The market trades down and we’re buyers of whatever we bought the straddle on. The market trades up, and we’re sellers,” explains Bartlett.

Parallax started as a floor-based market-making group on US regional exchanges and has evolved into a global relative-value/volatility-trading firm with a heavy emphasis in the US equity and index markets. The firm manages just over $3 billion across a range of funds.

However, the volatility Bartlett describes is actually suppressing volatility and is driven by demand for yield.

Taking a slightly different view of volatility is the chief investment officer at Man Group, Sandy Rattray. The London-based hedge fund group is the largest in Europe running both quantitative and discretionary strategies in all liquid assets globally, as well as active in the macro volatility rather than single-name volatility area.

Rattray sees three themes affecting volatility at the moment. First is politics. Central banks are trying to suppress volatility while politicians appear to be playing a “very different game. It doesn’t matter where you look in the world. Politicians are creating the circumstances for volatility,” he says.

Second is the growth of quantitative strategies, in all their forms, within and outside volatility trading. “One technique that has really worked for the last 20 to 30 years in systematic trading is scaling your positions by some measure of volatility: short-term, medium-term or higher-realised volatility, but usually not long vol. It doesn’t really matter what it is. Generally, it is not very long-term and quite short,” he noted.

However, as markets go down, volatility tends to go up. This feedback mechanism has caused many to believe quantitative strategies are causing market instability. “I don’t agree with this. I think volatility scaling, if everyone is doing it, creates an instability and

there are certainly a lot more people doing that,” said Rattray.The third factor is market microstructure. “From my perspective

you have a number of things coming together, with banks committing dramatically less capital to markets,” Rattray continued. “At the same time, you have an enormous rise of high-frequency traders. This is actually a better way of market-making than people with telephones on floors could do. However, these people don’t have anything like the market-making obligation that existed in the past. There is a clear instability that has come out of this,” he concluded.

Arnaud Sarfati, co-founder of La Française Investment Solutions (LFIS) , agreed that investors are looking for solutions due to low interest rates and the lack of perceived opportunities in the liquid markets. Liquidity is a continuing problem. “The environment is difficult to navigate whether you are short or long volatility,” he says. “It is a shifting environment.”

LFIS, which runs around €13 billion, combines investment management experience, derivatives expertise and specialist quantitative capabilities to offer clients differentiated solutions using a multi-asset approach to extract value and deliver long-term performance.

Bartlett said that providing liquidity has become a large part of his firm’s strategy. “Although it’s always been a consistent factor in our strategy, in the last four or five years we’ve been buying liquidity in about 75% of our trades,” he says.

Rattray has a different experience: he said that over the last 20 years when equity went down, bonds went up and “saved” investors. “You might reasonably think this is a normal state of affairs and it has been for 20 years,” he said. “But if you look at the previous 250 years, there has been no period of time where the relationship is consistently that when equities go down, bonds went up.”

Everyone now seems to accept that bonds diversify against equities: a notion particularly prevalent in the US pension fund industry and most insurance companies. One way to challenge this idea, said Rattray, is to ask what happens if there is a crisis in the bond market. “Are you going to be saved by the equity market? I think almost no one would think that,” he concluded.

Bartlett agreed and also saw big risks in this approach. “Thinking that what happened over the last 20 years will happen over the next is a bad way to risk manage a book, a portfolio or almost any set of risk that has equity and bond risk together,” he said.

Meanwhile, the actual providers of liquidity have changed, causing unstable correlations, with investors craving yield through a multitude of strategies. This has helped crowd some strategies

Search for alpha in a volatile world Alpha generation can be an elusive goal, particularly when trading volatility. Three different approaches to trading volatility were discussed by a panel looking at the role of systematic and carry strategies in finding profit in a high-volatility world

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and is also causing some volatility. “The VIX blow-up in February 2018 was

just a taste of the potential for the unwind of short volatility strategies,” says Bartlett. “We saw a $2 billion levered ETN that blew up because the S&P [Standard & Poor’s] sold off 5% in an orderly fashions and the VIX went to 48.” The idea that in any selloff you sell the spike in volatility is a false one, he said. “Just because it has worked well does not mean it will in the future. The effect is that the short-vol trade on the short end of the curve is crowded.”

Rattray had a more radical view. “When we first looked at the VIX in 2003, we didn’t much like it,” he said. While most think the way to make money out of the VIX is through exchange-traded funds (ETFs), Rattray has reservations. “The short ETFs may look attractive in the near term, but I think they are all bad because they are extremely unsophisticated strategies that have been packaged. A short VIX ETF cannot adjust and has to keep on buying to adjust its short position. This is not sustainable,” said Rattray.

“I’ve seen a kind of religious conversion where people believe backtests. You have these extremely simple strategies with people believing them. That’s particularly taken place in factor investing, a place where it’s modestly dangerous. The moment you get to non-linear products, it’s lethal,” he declared.

Sarfati sees market concentration rather than overcrowding as a problem. He also defends risk premia – around since the 1970s and a staple of LFIS’s strategies. “The big difference today is that risk premia have become very systematic, and so the market is much more concentrated. This leads to volatility of vol.”

To counteract this effect, LFIS emphasises diversification and making sure it is possible to scale positions within the portfolio. “This makes a difference,” Sarfati said.

For Rattray, the most crowded space is active equity management. “There is a shrinkage that’s taking place. Our job description is to take risk. People say they want you to take risks but actually they don’t want you to take very much at all. That’s a very odd sort of thing: you either want someone to take risk or you don’t and if you don’t, you’re better being in an index rather than with an active manager.”

Bartlett thinks short volatility is crowded and “will end poorly” because people do not appreciate the risks of the positions, coupled with the belief that bonds and equities are uncorrelated.

The availably of near-term volatility is another factor, particularly in US equities, where the demand is for skew, noted Bartlett. “That imbalance is basically where you can buy short-dated S&P gamma, say at eight to 12 implied vol, and sell six-month downside puts at 25 to 30 because of these large structural flows, the supply of vol from sellers and the demand of downside protection from hedging strategies. They are basically

buying the most expensive option and buying the market while selling the cheapest option.”

As usual, the Man Group, which runs large portfolios, has a different view. “We’re basically a long volatility business,” said Rattray. “Generally, we are short options, although extremely dynamic in how we manage risk. It is a relatively modest allocation for us and so from that perspective, if it goes badly, we think we’ll be okay in the other 95% of our risk.”

Man finds opportunity in volatility since positions need to be quite large by going across all of the markets. “You can get all sorts of interesting opportunities across the foreign exchange markets, for examples”, said Rattray. “We expect quite low Sharpe ratios in each of our systematic strategies and have relatively genuine diversification by building across as many different markets as possible. This has been our edge. We don’t do one-off large trades. We make money by being consistently in all these markets and making sure we’re present all the time.”

Sarfati prefers to run a dispersion book within his funds and diversify this way. “We trade geometric dispersion. We sell volatility on the index but can decide to enter a dispersion strategy where we buy a basket of volatility swaps on a single name but sell vol on the basket. We believe there is more opportunity on geometric dispersions.”

For Bartlett, the key to surviving is to take a relative-value approach, particularly in volatility. “We mistakenly thought that volatility was really cheap for five or six years. It turns out it’s just been really low.” He also recognised it is not possible to see the future. However, the market will always continue to present mis-pricings and identifying these is important.

He concluded: “Dispersion is a great strategy sometimes. But systematic dispersion can be disastrous. We made all of our money in 2010, 2011 and 2012 in dispersion coming out of the financial crisis. But dispersion hasn’t worked that well this year. Implied correlations have increased, and we see realised correlations also increasing. It hasn’t been profitable for us. To do it consistently, especially when implied volatility and implied correlations are low, is like picking up pennies from in front of a steamroller: it could be disastrous.” ■

Arnaud Sarfati, LFIS

Will Bartlett, Parallax Volatility Advisers

Sandy Rattray, Man Group

Laila Mukhey, Societe Generale

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Societe Generale & Risk Derivatives Conference 2019

In the Bible, Egypt suffered seven lean years followed by seven fat years. Japan has not had such as good outcome, with far more than seven lean years. Does the same fate await Europe? And will its population show the same patience?

The Japanese experience has been profoundly influenced by the expectations and behaviour of individuals and companies in the country, according to Peter Tasker, a strategist and co-founder of Arcus Research. He joined the debate at the Societe Generale/Risk.net derivatives conference live from Asia as a hologram – a technique that turned the discussion into a riveting insight into the differences and similarities between Japan and Europe.

Tasker set the scene. While Europe’s slow-growth woes began with the financial crisis, Japan’s problems began further back and were a whole economy issue. They became a self-reinforcing phenomenon because of the way people and corporations reacted to the slump.

“The reduction in investment led to low growth and there was no longer the multiplier effect because there was no investment. This impeded growth,” said Tasker. People on the whole were not interested in the idea of a pension so people just kept working.

“People want to work. They have a job and they continue to carry on working well into what was previously retirement age. There is an unprecedentedly high employment ratio and yet no wage inflation,” he explained.

At the same time, the private life of people in Japan shows another behaviour characteristic uncommon in Europe: even if they have a job, people live at home rather than buying their own property. In Japan, these children staying at home are called “parasite singles”.

“This same behaviour is happening in the corporate sector big-time. No one feels the need to invest or move on,” said Tasker.

As the rest of the world reacted to the financial crisis by aggressive use of monetary policies, leading to low and even negative interest rates, nominal GDP growth and in some cases negative government bond yields, the reaction of Japanese politicians was less aggressive.

“There is clearly an intersection between politics and economic and monetary policy. We are seeing a polarisation in many countries in Europe and elsewhere in the world. This never happened in Japan, where there is a great deal of social capital and cohesion. Pain is shared through the whole community. There is no pressure on politicians in Japan to try something radially new,” said Tasker.

However, the internalised national stress has led to a rapid rise in the suicide rate, particularly among middle-aged males. Yet there are none of the street demonstrations or expressions of anger prevalent in some European countries. “The message to Japanese politicians was different, and so their response was different,” explained Tasker.

While the Japanese are willing to live with mild deflation, it is not the same in Europe. Tasker believes Europe would not survive 25 years of continued low or negative inflation, slow growth and ultra-low interest rates. “Systems will not survive. My view is that sooner or later we will have more explicit reflationary policies taking advantage of extraordinary issuing terms and attempting to appease the exposed elements of a very unhappy public.”

Peter Fitzgerald, chief investment officer multi-assets and macro at Aviva Investors, agreed with this assessment. “Economists tell you theoretically there is no limit to negative interest rates, but when people and institutions get into distressed territory there are limits.”

The idea that people and institutions will continue to hold instruments where the yield is negative is not sustainable. It is not a way to make money, said Fitzgerald.

While equities are more resilient, Europe’s equity market is coming from a very different place than the market in Japan. Price/earnings ratios on the Japanese market went to 75 times, Europe’s is closer to 12 times.

He also pointed out that the social structure of Japan is different to Europe, so retail investors behave differently.

“We are seeing more search for yield, and this is opening opportunities. Structurally, this makes implied value look good. Underperformance expectations driven by that search for yield is introducing opportunities,” noted Gwilym Satchell, multi-asset portfolio manager at Invesco.

He also believes the climate agenda may give politicians a way out of sluggish growth by giving them the incentive to inject stimulus into economies through environmentally related investments.

How best to allocate capital is constantly being debated in Europe. While the cost of monetary policy is one thing, how to get capital into profitable projects while rates remain low is proving more difficult, notes Aymeric Forest, global head of multi-asset investing at Aberdeen Standard Investments (ASI).

He points out that in the 1990s the Japanese government changed frequently. Policies were tried and failed. There was academic discussion about fiscal policy and budget equilibrium. “These are the same discussions you have having in Germany now. You are seeing the cost to government and political parties. [French president] Macron focused on an expansive policy, and we are seeing a move towards fiscal policy expansion.”

However, there are different fundamental drivers and demographics in Europe compared with Japan. “Europe is not an island like Japan,” he said.

Tasker said inflation is what will bring Europe out of its malaise.

Europe eyes the pitfalls of Japanification Does the cultural and demographic experience of Japan apply to a heterogeneous grouping of nations that have no common monetary policy or a unified social outlook?

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“Some inflation is required. I’m not sure which country will be the first out of the blocks. We’re getting to the situation where even the chief economist of the IMF is cheerleading for more expansionary fiscal policy.”

The dilemma for Europe is different from Japan. For example, politicians question whether they should keep interest rates way below equilibrium levels. “In Japan, if you reflate deliberately, the bondholders are Japanese and are both beneficiaries and victims,” Tasker noted. For Europe, and countries such as the UK, where the bonds are held largely by foreigners, it is a different story. “Would the Bank of England be tempted to reflate and see what happens? The politics of the eurozone are even more complex.”

Fitzgerald said politicians only tend to react to a crisis and even then the response can be sluggish, pointing to the eurozone crisis that needed the European Central Bank (ECB) to step in to make an impact. “Politicians need to respond and we need to get them to realise what is needed.”

Japanese GDP since the 1990s has been flat with outright deflation, but Europe still has inflation, albeit low. “There is still a possibility of a major fiscal response in Europe. But in Europe there is no overarching government unlike Japan, and some countries, like Germany, need significant structural and fiscal policy changes,” he said.

Forest agrees that a more granular and selective stimulus is needed. “We’ve had the value growth debate and we’ve seen

how cheap value can become. If growth is scarce, investors pay a premium. Japanification is not new. In this environment, we need to focus on defensive growth, high-quality cashflow and more dividend growth with some consumer discretion,” he said.

Bank lending in Europe is increasing, said Alan Higgins, chief investment officer at Coutts. He predicted that if large national champion banks committed to a high level of dividends, there would be more equity growth within the banking sector. Looking at the banking market as a whole, he said it is a “leap of faith” for investors to believe that some banks will continue to pay dividends.

“There is no money to be had in equities,” declared Fitzgerald. “We have little exposure in Europe. We remain to be convinced that there is value. There are some attractive dividends in Europe, but the market is saying this is not sustainable. Our view on equities in general and particularly in Europe, remains cautious,” he said.

With low rates, the euro is behaving more like the yen, said Satchell. There are also worries about the European project. “That’s a real risk, a mild one, but still one. We see the euro as a defensive asset, but dollar and yen is where you go in a real crisis,” he said, adding that investors need to look in the right places for real value. For example, holding on to long volatility looked good for a long time but has not paid off.

Higgins thinks there is less yield hunting by investors in Europe, in part as they move to less liquid markets. For example, there is a move to diversify through real estate funds that are not mark-to-market.

If there is too much capital chasing of too few assets, will that lead to a destruction of wealth in the future? Tasker said the answer is that we will not know until after it happens. “Looking at the Asian equity markets, there are not particularly stretched valuation-wise. Equity earning yields in Japan are at their highest since 1970 and are finally paying out more,” he said. However, he touches on an area where there could be vast wealth destruction: fixed income. “We’ve never seen anything like this in human history with negative interest rates. This could get very bad at some point.”

In an environment where the Japanification of Europe is still a worry for investors, some are able to find values. Fitzgerald said his top trade idea is equities over a five-year time frame. “If you want to preserve capital, stick to the liquid side of the market and the ECB will buy from you.”

Satchell is trying to find idiosyncratic opportunities. “A lot of things are mispriced,” he said.

For Higgins, value is in bonds. “We are looking at the US curve and particularly the two and 10s and looking for hedges. If the macro environment goes wrong, interest rates go to zero and the curve steepens, you will make a return,” he said, adding that he sees this as a good hedge without taking duration risk.

Forest prefers going long the 30-year Japanese government bond with a cash hedge and shorting the 30-year Bund while potentially playing some of the fiscal trends. ■

Peter Fitzgerald, Aviva Investors

Cassandra Cox, Societe Generale

Peter Tasker, Arcus Research

Alan Higgins, Coutts

Aymeric Forest, ASI

Gwilym Satchell, Invesco

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