Head of Equity Strategy
Summary: Equities are currently at edge with market sentiment and the VIX curve signalling that either the market extends into a meltdown or stabilises in order to likely stage a rebound. In today's equity note we also reflect on hedging amid high volatility and Apple's decision to put manufacturing in India which sends a strong signal that global supply chains are changing fast these years amid rising geopolitical tensions.
It is either meltdown or big bounce from here
Yesterday’s price action was brutal with S&P 500 futures closing at a new record low for the current drawdown cycle but still above the intraday lows from June. The VIX Index pushed higher together with the USD and long-term US bond yields, and the VIX forward curve inverted to levels just at the edge of when it becomes a kick starter for a market meltdown. This morning S&P 500 futures are attempting to rebound up 0.9% reflecting a technical move as no new news has come out. As we have highlighted in recent equity notes, sentiment among investors is extremely bearish and with determined and hawkish central banks we might have the right setup for a meltdown of 5-6% in a short timespan should S&P 500 futures break below the 3,640 level which was the intraday low back in June. The USD Index will dictate where we go from here and should the market retreat across yields, volatility, and the USD, then S&P 500 futures could easily rebound to the 3,800 level.
A quick reflection on options at elevated volatility
In many of our client conversations we hear talk about hedging the downside and for many a simple strategy of buying puts on the market seems like a good strategy. The outstanding number of put options on US equities has also exploded recently reflecting the demand for puts. One thing to keep in mind is that with the high realized and implied volatility and inverted VIX curve, options have become expensive. It is like buying a fire insurance when the fire has just started. The option market is already pricing in significant moves from here so that at-the-money puts on S&P 500 with expiration on 16 December cost around 5% in premium. That means that the put options only become a hedge in the event of a significant market meltdown. How likely is a move beyond -5% over the next 57 trading sessions (the time to expiry)? Using daily returns since 1 January 1950 on the S&P 500 it happens in 13.5% of the time.
However, at this point in the game it would likely be better to do a delta-one hedging (meaning instruments that moves 1-to-1 with the underlying) using CFD Index trackers or futures. This form of hedging gives immediate protection but also caps the upside on a rebound depending on how much of your portfolio you are hedging, but paying 5% in premium for a put option also subtracts from the total return.
Apple is sending big signal with manufacturing in India
Apple announced yesterday that it will manufacture a portion of its iPhone 14 in India signalling a shift in its supply chain structure. Apple has previously depended on China but with the tensions between the US and China, and the recent US CHIPS Act the US government is telling US companies to reduce their exposure to China. During the Trump period US companies adopted a China + 1 strategy which meant most of production in China and a little in some other country, often in Vietnam. With the war in Ukraine and sanctions against Russia, multinational companies are rethinking their supply chains and the associated risks. These considerations combined with the many lockdowns in China due to Covid are causing companies to move manufacturing to India, Vietnam, and Indonesia. This trend leans well into an FT article yesterday by Ruchir Sharma on the so-called seven economic wonders of a worried world highlighting that the seven countries Japan, Vietnam, India, Indonesia, Saudi Arabia, Greece, and Portugal are all doing much better than the rest in terms of inflation and stock market performance.
In any case, we have long talked about India as one of the biggest beneficiaries of the rivalry between the US and China, and the equity market is constantly valuing the India equity market at the highest earnings multiples of any country in emerging markets reflecting the high expectations. Among our equity theme baskets our India theme basket is the fourth best performing basket this year down only 11.4% compared to a decline of 24.5% for the MSCI World. Another theme basket which we expect to benefit from this outsourcing of production from China is the logistics industry because the change in supply chains will make them more complex and fragmented which will benefit profitability longer term for the industry.
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