Weakness Trumps Fear: What Matters

by Ashraf Laidi
Jan 15, 2016 16:29 | 29 Comments

One notable reason the VIX is trading at only half the level seen in August (53.0), a time when equity indices plunged near today's levels is related to market's absorption of risk versus macro negatives.

The China devaluation of August 24 came as a complete surprise to financial markets, which were neither ready for the PBOC's FX manoeuvres, nor prepared for the dangers of rapid decline in the currency of the world's biggest buyer of commodities as they are today.

Indeed, the 98% jump in the VIX of August 24 was also propagated by soaring volumes of VIX and VIX-related products (VIX ETFs and leveraged ETFs), as well as high-frequency trading of these products by banks and algo firms.

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Weakness Trumps Fear: What Matters - Retail Sales Us Jan 14 (Chart 1)

Known Unknowns

Setting the technical intricacies aside, markets in August were not positioned for a surprise from China and certainly not aware of the intricacies of the yuan's daily fixings and the implications of the onshore vs offshore pricing. At the time, the primary concern was whether the Fed would raise in September or December, as well as the more familiar emerging market concerns.

Today, the sources of market selloff and macro deterioration are not necessarily new or unexpected (tumbling CNY, falling CNY, disappointing macro data) but their implications for eroding capex, widening credit spreads, quantitative FX tightening by emerging markets and forced liquidations by Gulf sovereign wealth funds are more ominous and immediate for the market. 

The Real Risk Metric

Although the VIX remains inside the 20-40, a level considered as neutral, there are more relevant metrics of macro risk/weakness, namely more elevated high yield spreads (713 bps vs 560 bps in August 24 at 29% higher), flatter yield curve (10-2 spread at 1.19% vs 1.44% in August 24 at 17% higher), oil prices 23% lower and finally a substantially weaker readings in manufacturing and retail sales (see chart).

Fear vs Complacency

Downside risks may more anticipated today but market participants, but their confluence and intensity has far reaching implications than five months ago. We expect oil prices to reach $17 (unchanged supply from Saudi to accommodate Iran's production, falling demand from the Gulf and China, halted exploration projects and policy easing from Canada) to accelerate the deflationary pressures and push the Fed back into negative interest rates in Q3 of this year.

Comments (Showing latest 3 of 29) View All Comments
Ashraf Laidi
London, UK
Posts: 0
8 years ago
Jan 29, 2016 0:46

As far academic books:
"Animal Spirits" by Shiller.
"Depression Economics" by krugman.
“The Only Game In Town: Central Banks, Instability and Avoiding the Next Collapse” by El Erian


Not sure how long the safehaven to USD will last if a new crisis prompts the Fed into easing. Remember: unlike in 2007-08 when the tightening was led by the Europeans and EMs, the Fed at the time was in neutral mode. Today it's the opposite: Fed is in tightening move (if you can call it that) & rest is in easing.


United States
Posts: 0
8 years ago
Jan 17, 2016 16:28
Ashraf, great points. The rapid deterioration in the world economy you describe poses a serious challenge to portfolio managers. In the US, there is ongoing deflation, a growth slowdown in manufacturing, and corporate profit recession. A rebound in equities is dubious and the risk of another downward move is substantial.

Until ongoing worries about the Yuan subside, macro data improves, and credit spreads narrow, I would imagine that asset allocation models should favor cash, fixed income, and currencies.

In addition to short-term trading of FX spot and crosses, how would you feel about allocating capital to the USD and Yen via the ETFs UUP and FXY?
Ames, United States
Posts: 0
8 years ago
Jan 15, 2016 17:55
What other books would you you recommend to read to gain more knowledge after your book? Academic books?