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Editor's Note: Hamish Risk | October 14, 2020
We’re metaphor heavy in today’s briefing. US tech stocks rip higher, a move not seen since August, so we take a look at what is driving the phenomenon. A safe haven play amid worries over global growth as US politicians wrangle over further stimulus measures, many believe the move has been exacerbated by hedging activity stemming from the options market. However, as Macro Risk Advisors explains, the culprit may not be, as many assume, a large whale of an investor, but good old-fashioned retail activity. Whatever the cause, Societe Generale highlights why now may be the time for investors to abandon the volatility of US big tech for the calmer shores of Europe and Asia, while Ned Davis Research sets out why gains in record-breaking Chinese stocks in particular are likely to continue to drag EM indices higher. Elsewhere, Deep Macro examines the effect Covid-19 is having on the US economy, and explains why investors need to keep track of concentration levels of consumer activity amid particular sectors to truly understand the long-term effects of the pandemic. In today’s ESG segment, we highlight research on the materiality of hidden liabilities, citing research from a Harvard University study that shows how hidden environmental liabilities impact sales and operating earnings of companies, and which typically are not being reflected in the environmental ratings from the big rating agencies.
equity derivatives FAANGs Macro Risk Advisors
1. Piranha feeding frenzy – are option traders upending the S&P volatility smirk?In light of the surge in tech stocks in recent days which many believe has been triggered by gamma-hedging option-related activity as last witnessed in August, Ed Tom at Macro Risk Advisors has put out a timely note examining the recent unusual interaction between spot and large indices such as the S&P and the QQQ. Given there is greater incidence of days when the market is up and implied volatility rises as well, he examines the cause. Tom notes that many commentators have speculated that the anomaly has been triggered by a large “whale” such as Softbank bidding up call options on FAANMG names. However, in analysing FAANMG options trading activity on days with materially strong positive spot/vol correlation, he finds that the anomaly may instead be driven by the aggregate actions of retail investors – as he puts it, more akin to a piranha feeding frenzy than that of a whale trade. While noting the possibility that one or more big whales may be disguising their activity via algos to mimic retail activity, Tom says his analysis nevertheless supports the possibility that retail investors may have a larger role in index level volatility dynamics than conventional wisdom dictates. Indeed, he says the momentum trading style of many retail investors suggests that a resurgence in tech stock performance could restart the “stocks up / vol up” dynamic that investors have experienced post-Covid.
Asia Global equities SG
2. Use current strength to switch out of US big techAlain Bokobza at Societe Generale says investors should use their current strength to diversify away from US big tech stocks as the sector becomes more volatile. He notes volatility in the sector is not far off levels seen in the tech bubble in the early 2000s and comes at a time when an improving economic outlook and the prospect of a more challenging regulatory outlook threaten to undermine US big tech’s remarkable outperformance. Bokobza recommends investors look instead towards affordable growth in Asia and Europe. Valued at close to $2,500 billion, he says he sees the Asia Tech market as an alternative to US tech, and says while it may face downside risks from potential momentum trade reversal and escalating US-China political tensions, the sector is not yet in bubble territory while earnings momentum remains positive despite the coronavirus pandemic. As for Europe, Bokobza says its attractions stem not just from more expansive fiscal policy and debt mutualisation in the eurozone, but also in the shifting structure of the stock market. Benchmark indices, he notes, include fewer banks, energy companies and telecom operators, and more tech and quality names. Indeed, three of ten largest companies by market cap in the eurozone are tech stocks, says Bokobza, and unlike their US counterparts, he notes a lower volatility concentration in the European tech sector, providing fertile ground for single-stock trade ideas.
Asia China equities Ned Davis Research
3. China trend gains tractionAs the total value of China’s stock market climbs to a record high of more than $10 trillion, Tim Hayes at Ned Davis Research has issued a note explaining why the country’s equities have become so supportive of EM performance in general. As he explains, Chinese stocks, which have been boosted by the strength of the country’s economic recovery following the coronavirus, now carries 41% of the MSCI Emerging Markets Index, up from 34% last year. Hayes, who has an overweight recommendation on China and EM equities, says China remains first in his 49-market ACWI scorecard, while its longer-term uptrend remains intact, with both concentration and valuations not at excessive levels. Furthermore, he notes a secular dollar downtrend, combined with correlating uptrends in commodities in gold and commodities, would increase the chances for a long-term run of relative strength in Chinese – and EM – stock indices. It’s too soon to draw conclusions about the secular outlook, says Hayes, but the weight of the evidence is clear about tactical allocation over the cyclical horizon: China is maintaining decisive uptrends in absolute and relative strength.
economic disruption US equities Deep Macro
4. Is Covid an asteroid or a forest fire?Jeffrey Young at Deep Macro has issued a note aimed at setting out a framework for discovering whether the US economy is getting more concentrated as a result of the covid-19 pandemic. To achieve this, he assesses different sectors, asking whether covid-19 has acted like an asteroid – a shock that comes from outside the system, creates a great deal of destruction, and creates a post-shock state that the system had not evolved to before the asteroid hit – or a forest fire, which is also destructive, but after which diversity returns quite quickly and the system is ready for other shocks. So far, says Young, the evidence is mixed, with higher concentration in sectors such as grocery stores and building material retailing suggesting an asteroid-like effect, while fast food, clothing and general merchandising are exhibiting less concentration, suggesting a more forest fire-like effect. He says while it is too early to tell which effect will dominate and that it will not have much impact on the business cycle in the near term, it is nevertheless an important question for investors. As Young notes, firms in a more centralised economy would have more market power, which would ultimately raise prices and restrict the supply of goods and services, and a more centralised, less diverse economy could be less resilient to certain types of shocks. At the same time, he notes, some firms that have gained market share provide benefits that even opponents would have to acknowledge.
ESG materiality Harvard University
5. ESG: Hidden liabilities and materialityIt is often said that ESG investing is not about increasing returns but a method of risk management. The constant challenge for investors is to determine and measure what are the ”material” risks that they should care about when they invest in individual companies and particular companies. In other words, how much will the share price of company x fall by, if a hitherto hidden risk is exposed. Say for example if environmental damages become salient due to an accident, a spill, or a sensationalised media report. or if they are prised as liabilities by regulators forcing companies to pay for their emissions and water usage on a comprehensive basis. This could then the significant decline in income will likely lead to a dramatic decline in the share price, according to researchers at Harvard University (Hat tip to Joachim Klement at Liberum for highlighting this research). And here’s the rub. If investors were to rely on environmental ratings from the big rating agencies, they would not know about this since the correlation between environmental ratings and these hidden liabilities is essentially zero and if anything, slightly negative, according to the study. The researchers at Harvard provide some insightful findings when it comes to these ”hidden” liabilities. The study used the emissions of different greenhouse gases and water between 2010 and 2018, and then priced them with the best models currently available before comparing these environmental damages to the sales and operating earnings of companies. What they found was that the global median of hidden environmental damages was 2% of sales or 20% of operating income, but in 11 out of 67 industry groups they looked at, the hidden environmental liabilities were above 10% of sales or 100% of operating income. So, as above, say regulations demanded companies pay for their emissions and water usage, this could lead to a significant fall in the share price. Their research showed that every doubling of the emissions relative to sales leads to a c.5% decline in the price/book-ratio of the company. The good news is, however, that corporations can do something about it. The Harvard researchers show that only about 60% of these hidden liabilities are determined by the industry the companies is operating in. The rest is due to company-specific factors. And that means management can reduce its risks from hidden liabilities quite significantly if they want to.