Over the weekend, before the collapse of XIV, JPMorgan reflected on the collapse in stock and bond prices that had smashed Risk-Parity funds lower.
JPMorgan warned that as the bond market sell-off gathered pace over the past weeks, it was raising concerns about the impact on equity markets. This is especially because the bond-equity correlation, which has been predominantly negative since the Lehman crisis, has started creeping up towards positive territory.
The 90-day correlation between stock (SPY) and bond (TLT) markets has surged ominously in the last few weeks…
In turn this raises concerns about de-risking by multi-asset investors who depend on this correlation staying in negative territory such as risk parity funds and balanced mutual funds? How worried should we be about de-risking by these two types of investors?
And this week (worst weekly drop in Risk-Parity funds since June 2013’s Bernanke Taper Tantrum)…
As mentioned above, these types of investors benefit from the structurally negative correlation between bonds and equities as this negative correlation suppresses the volatility of bond/equity portfolios allowing these investors to apply higher leverage and thus boost their returns.
But, as JPMorgan points out, the opposite takes place when this correlation turns positive: the volatility of bond/equity portfolios increases, inducing these investors to de-lever.
But JPMorgan offered hope that this vicious circle of de-leveraging could be stalled – and had been in the past – by dip-buyers from greater-fool retail inflows.
In the past, just as we have seen this year, these risk-parity-correlation tantrums have been cushioned by equity market inflows, and we note that, in particular, YTD equity ETF flows have surpassed the $100bn mark, a record high pace.
If these equity ETF flows, which JPMorgan believes are largely driven by retail investors, start reversing, not only would the equity market retrench, but the resultant rise in bond-equity correlation would likely induce de-risking by risk parity funds and balanced mutual funds, magnifying the eventual equity market sell-off.
Which could be a problem…
As Bloomberg reports that investors yanked a record $17.4 billion from the mighty SPDR S&P 500 ETF over the past four trading sessions. The $8 billion removed on Tuesday alone was the third-largest daily withdrawal in the post-crisis era.
The last time redemptions were close to matching this frenetic pace? In late 2007, when cracks in U.S. equities began to show before the global financial crisis unfolded.
While JPMorgan stated over the weekend that they were “reluctant to attach too much importance to the outflows of only one day,” the risk of a more significant equity market correction will naturally rise if these outflows extend into next week… and they have!
Put more simply – either we get a major equity ETF inflow to offset the risk parity hit, or markets are going a lot lower, a lot faster as the forced deleveraging accelerates.