Volatility highest since financial crisis, Morgan Stanley recommendation

Reuters / Brendan McDermid

• A combined volatility measure covering 14 assets across
  four major market groups is on pace to finish the year at its
  highest level since 2008, according to Morgan Stanley
  data.
• One of the main underlying reasons for this spike in
  price swings should give pause to investors of all types, the
  firm says.

If you’ve noticed a recent uptick in market volatility, it’s not just your mind
playing tricks on you. By multiple measures, price swings have
stormed back in a big way.

It’s a newfound phenomenon facing asset classes of all shapes and
sizes — from stocks to rates to commodities. And while an optimistic
trader might tell you that turbulence creates opportunity, others
will be quick to express concern about the potential for quick
losses.

The situation is even more pressing when you consider not just
benchmark gauges of volatility, but how price swings have
transpired relative to implied forecasts.

According to an analysis conducted by Morgan Stanley, a combined measure of
14 assets across four major market groups is on pace to see the
largest number of three-standard-deviation moves, relative to
expectations, since 2008.

Morgan Stanley

With that in mind, the sheer observation that volatility is
higher is considerably less interesting
than why it’s so elevated. In diagnosing the
primary reason for bigger price swings, Morgan
Stanley arrived at a conclusion that should have investors
on edge.

The firm found that a lack of liquidity is perhaps the most
compelling explanation for the spike in price swings. As markets
have multiplied in size since the last financial crisis, the
capacity of dealers responsible for transacting trades has
dwindled. Those two elements have combined to create a situation
where asset losses are exacerbated during tough times.

“While markets have grown steadily over the last decade, the
means to trade them have not,” Andrew Sheets, chief cross-asset
strategist at Morgan Stanley, wrote in a client note. “Dealer
holdings of corporate bonds have shrunk from 3% of the market to
just 0.3% today. While this means that dealers themselves have
less to liquidate, their capacity to move risk to a new buyer may
be limited and require larger repricing of the asset class in
times of stress.”

Morgan Stanley

So what’s an investor to do in these trying times? Lean into the
volatility by loading up on hedges, of course, Morgan Stanley
says.

More specifically, the firm suggests investors should use options
in a manner that drives a measure called “skew” higher. Skew —
which reflects the degree to which volatility is expected,
thereby serving as a hedging proxy — is already at the high end
of its range, but has room to move even higher, Morgan Stanley
says.

But Sheets’ recommendations don’t end there. He also offers
specific trades for three areas of the market he sees as
particularly vulnerable to greater price swings:
credit, small-cap equities, and
Brent crude. They are as follows:

(1) Buy 50-day puts on high-yield credit-default
swaps

“Credit best represents the themes we are discussing here,”
Sheets said. “One of the biggest beneficiaries of the QE hunt for
yield, credit has seen a doubling of the market size while
simultaneously suffering a downgrade in market liquidity. Credit
spreads are too tight and vol too low.”

(2) Buy 6-month 45-day/25-day Russell 2000 put
spreads 

“Small cap relative performance and positioning has been very
extended,” Sheets said. “Russell 2000 vol levels are low and vol
spreads to S&P 500 are compressed, making small cap hedges
attractive.”

(3) Buy 2-year at-the-money forward calls on Brent
crude

“While we still think that the medium-term demand-supply dynamics
are favourable for oil, the bullish positioning, near-term
geopolitical risks and trade uncertainty make buying longer-term
calls a defensive way to express this view,” Sheets said.