US equities and a spasm of risk aversion

Dubai - A spike in volatility is the kiss of death for US debt, writes Matein Khalid

I had written a column two weeks ago outlining my view that US equities faced a dangerous autumn and the S&P 500 index was set for a fall of 150 points. However, even I did not expect the S&P500 index to fall 52 points on Friday (the Dow dropped 394 points and NASDAQ 133 points), its worst performance since the Brexit shock. It was even more alarming that the Volatility Index (VIX) spiked 38 per cent in a single trading session after the equities sell off accelerated. The immediate catalyst for the stock market's malaise was North Korea's nuclear test and Boston Fed President Eric Rosengren's rate hike musings.
Yet North Korea's nuclear brinkmanship has defined Asian geopolitics since the death of Kim Il Sung in 1994 and a Fed rate hike in December was telegraphed into Chicago money market futures. These factors alone do not explain the market's sudden U-turn. The Nasdaq hit a record on Wednesday at 5284, then sank to 5,125 points on Friday. The Volatility Index (VIX) was abnormally low all summer, as low as 12 when the markets reopened on Tuesday after the long Labour Day weekend. Yikes!
It is significant that all 10 S&P500 sectors fell on Friday, though financial dropped the least as the yield on the ten year US Treasury note rose to 1.67 per cent and the US dollar resumed its safe haven role. The 200 day moving average on the S&P 500 is 2060, 65 points above Friday's close. If the stock market does not hold 2060, this sell off could become ugly next week and be remembered in history as a ursine "back to school" Wall Street temper tantrum.
The nine per cent rise in the stock market since Brexit had created an overbought, overvalued (17.8 times forward market that was vulnerable to the slightest hint of bad news, such as the North Korean test, the Boston Fed (a dove on the FOMC!) president's rate comment or an uptick in the US dollar. There was poor market breadth, dismal earnings growth and growing nervousness about Hilary Clinton's lead over Donald Trump as the endgame for election season begins. I was shocked by the Pavlovian rush to embrace US equities by even seasoned fund managers I met on a recent trip to Europe. A more nuanced paradigm of world finance would serve investors well. Governor Kuroda of the Bank of Japan and Mario Draghi of the ECB have both acknowledged that they have reached the limits of central bank monetary surplus. This triggered a sharp rise in Japanese and German bond yields that led to the spike in the US Treasury bond yields.
Central bank money printing caused the epic rise in global risk assets. If central banks back off, the seven year bull market loses its most fundamental anchor. Of course, if the Fed obsesses about financial markets, the markets obsess the Fed. If the S&P 500 index continues to fall amid a rise in volatility, there is zero risk of a rate hike when the Yellen FOMC convenes on September 21.
A spike in volatility is the kiss of death for US high yield debt, the junk bond market created by Mike Milken and the failed I-bank Drexel Burnham Lambert. Note that the high yield index fund (symbol NYG) is up 18 per cent since the energy bond sell off in February. Average yields were 10 per cent in February but have compressed to a mere six per cent now. The global scramble for yield has led to a tsunami of new issues by companies whose debt is as toxic as it is leveraged. A credit world where Sanofi and Henkel can issue negative yield corporate debt is also a world where leveraged lambs are led to the slaughter. If markets have veered from greed and fear, as a 38 per cent spike in volatility suggests, it is time to short the US high yield exchange traded fund (symbol HYG). Default rates have begun to creep higher. Oil prices are not the only variable in the junk bond market. Current spreads do not compensate for rising duration and default risks. Life insurer shares are highly leveraged to a rise in interest rates. This makes MetLife, which trades at an earnings multiple of 7, a natural bond market hedge.
Note that Brazil's index fund EWZ sank six per cent on Friday as even the whisper of a Fed rate hike means a bloodbath for emerging markets. The Philippines ERF fell eight per cent for the week thanks to Duterte. The Russian equities index fund (RSX) is also a short at 19 for a 17 target.