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Equity Derivatives Strategy
Equity 2014 Review and Outlook
Executive Summary
Volatility across asset classes and in particular in Equity is being
dragged down by a mixture of fundamentals and a change in the
structural demand for investment products that seem durable and
may force a general re-allocation to Equity – although looming risks
remain
Credit Suisse Research Outlook for 2014 confirms this trend, with
modest growth, low inflation and diminishing potential, good Equity
prospects, but potential risks centered on spillover effects of
Central Bank policies
Fed Tapering will be the main event for 2014, however we identify a
few other dislocations that could disrupt the markets in the coming
months: the return of leverage, Japan’s expansionary monetary
policy, Bond/Equity and FX Equity re-correlation
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Another Great Moderation in
Equity?
The factors behind volatility compression
The Great Moderation refers to the 2004/2006 period which saw
sustained Equity performance along with record low volatility
Implied and realized volatility in global Equity markets have
reached Great-Moderation lows, making Equity one of the best
performing asset classes – Why?
The conjunction of macro
stabilization, good corporate
earnings prospects and
synchronized QE creates a
bullish, volatility-suppressing
environment
At the same time, record-low
real yields force yield-starved
investors to investigate
alternative investments – often
short volatility
1Y Implied and Realised Volatilities –
Global Equity Benchmarks
60%
50%
Average 1Y Implied
Volatility
Average Realised
40%
30%
20%
10%
0%
2003
2005
2007
2009
2011
2013
Source: Credit Suisse Equity Derivatives Strategy
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Macro are supportive of Credit and Equity
Macro stabilization in 2013:
− Global growth of 2.9%, in line with 20Y average
− Emerging Markets are the largest contributors to Growth
Better corporate earnings
prospects:
− Record high margins
− Sustained by lower interest
charges, wage growth,
taxes, and better regional
diversification of earnings
SX5E 1Y Implied Vol vs iTRAXX Europe
50%
45%
40%
35%
30%
25%
20%
Hist. Since 2004
15%
"Last"
10%
0
50
100
150
200
250
Source: Credit Suisse Equity Derivatives Strategy
5
More QE and more synchronised QE
Low Central Bank balance sheet expansion in 2012
Synchronized QE in 2013:
− Fed: $85bn expansion in 2013 vs. $40bn in 2012
− BoJ on track to double its
balance sheet by 2014
− ECB under political pressure
to do more
How Equity volatility is affected:
− Excess liquidity supports
equity market valuations and
lowers Equity Risk Premium
− Implicit Put on Equity
reduces the need for hedges
Excess Liquidity vs PE Expansion
Source: Credit Suisse Equity Research
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The challenge of Yield Compression
Investors have preferred the perceived security of “safe assets”
despite earning negative real yields, while assets considered riskier
(Equity, Corporate Credit) are yielding above historical average on
reduced risk
Lower yields pose an unprecedented challenge for the Investor:
− Increases value of future liabilities
−Investors
Decreases
hedging portfolios
Long-term US Real Yields
are returns
looking on
to either
− Re-allocate to Equity
− Allocate to alternative
investments (Smart Beta,
Emerging Markets Bonds,
Alternative Risk Premia)
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Generate Yield through Alternative Risk Premia
Current low yield environment is not supportive for Equity
participation products. Structured Product issuance has
concentrated on yield products (e.g.: Auto-callables) which
compress long-term vol and skew
SX5E, S&P and Nikkei 5Y Skew
Institutions have continued
developing their pure volatility
activity with one additional
objective: yield extraction,
while regulatory news flow
decreased the demand for
long-term volatility
0.03
0.02
0.01
0.00
30-Dec-04
SX5E
S&P
01-Jul-07
30-Dec-09
30-Jun-12
N225
Source: Credit Suisse Locus
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The “Smart Beta” Alternative: High Div Yield
Smart Beta benchmarks are designed to provide superior exposure
to a given investment theme: for instance the EUROSTOXX Select
Dividend 30 selects high yielding stocks and provides 5.5% div
yield
Flows into High Dividend Yield funds have outpaced flows to all
Equity funds since 2009
The performance of the High Dividend indices tends to be
negatively
government
bond
yieldsOutperf vs 10Y Treas. Yield
Relative
Flow tocorrelated
Div Funds vsto
Equity
FundsS&P 500
Div Index
Source: Credit Suisse Equity Research
Source: Credit Suisse Equity Research
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Volatility Supply and Demand in
2014
Institutions/Fundamental Long Shorts
General Outlook:
− To heck with hedging after last
year’s 30% market rally and
disappointing performance in
2012
− Levered Delta: Long Shorts
outperformed thanks to low
correlation; more single stock
directional option trades
Alpha Availability Index
Source: Credit Suisse Equity Derivatives Strategy
2014 Trading Implications:
− Return of interest for European
underlyings given better outlook
for European equities
− Potentially more interest for vol
premium capture in the US given
expected modest performance
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Volatility Hedge Funds
2014 Trading Implications:
− Dispersion (1Y correl at 60) has
become statistically unattractive
− Short Vol still interesting trade
(SPX 1Y Var at 19.9 vs expected
11% realised)
VIX vs Subsequent 1M Realised Vol
Source: Credit Suisse Equity Derivatives Strategy
Cond. P&L of SPX Dispersion (100
60%
vega)
6M MSCI World Realised
General Outlook:
− Volatility Hedge Funds as a
group (HFRX) posted their
second best year on record due
to performance of opportunistic
short vol
− Volatility long short strategies
recorded a 2.5% loss for the
year because of resilient vol of
vol
-60%
50%
40%
30%
20%
10%
0%
-40%
-20%
0%
20%
40%
60%
80%
% Change in NYSE Margin Debt
Source: Credit Suisse Equity Derivatives Strategy
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Pension Funds
General Outlook:
− Recent equity strength has
allowed funding shortfalls to
narrow
− Interest rate increase in
corporate segment and
regulatory changes reduced the
present value of liabilities
US Pension Funds Deficit
Source: Milliman
2014 Trading Implications:
− Potential de-risking with Equity
markets at record highs
− Little impact on equity volatility
as only 1% of pension plans
actually hedge and typical put
spread collar strategy has
minimal vega impact
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Structured Products (Retail)
General Outlook:
− Issuance complicated by low
level of interest rates and low
level of equity volatility
− Typical product embeds going
short a DOI put option in
exchange for an annual coupon
with autocollable feature
Vega Profile of 1Y DOI SX5E Put (bar
2000)
Source: Credit Suisse Equity Derivatives Strategy
SX5E, S&P, Nikkei 5Y Skew
2014 Trading Implications:
− Depressed long term implie
volatilities and skews
− SX5E dividend and repo
dislocation, as short long term
forward exposure is hedged with
long futures
0.03
0.02
0.01
0.00
30-Dec-04
SX5E
S&P
01-Jul-07
30-Dec-09
30-Jun-12
N225
Source: Credit Suisse Locus
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Credit Suisse Global Outlook 2014
Key Points
Modest growth, low inflation and diminishing potential: the 2014 global
economy looks to be the most orderly in many years on a stable triangle
of.
Monetary policy in 2014 is likely to remain both highly stimulatory and
highly innovative: the ECB could ease further through LTRO or negative
deposit rate, BoJ could announce a 30% increase in the pace of monthly
Fed Tapering: started in
JGB purchase
Global Growth 2014 Forecasts
December (vs CS January
2014E
Annual Average
Q1
Q2
Q3
Q4
12
13E
14E
15E
Forecast) leading to rally in
Global
Real GDP (q/q3.6
ann)
3.4
3.8
4
3.1
2.9
3.7
3.9
Inflation (y/y) 3
3.3
3.1
3.4
3.1
2.8
3.2
3.5
the dollar and higher rates
DM
Real GDP (q/q2.2
ann)
1.8
2.6
2.5
1.5
1.1
2.1
2.2
Inflation (y/y)1.1
1.5
1.6
1.9
1.9
1.3
1.5
1.9
US
Real
GDP
(q/q
2.5
ann)
2.7
3
3
2.8
1.7
2.6
2.8
EM under pressure: narrower
Inflation (y/y)0.9
1.2
1.3
1.9
2.1
1.4
1.3
2.1
Japan
Real
GDP
(q/q
3.1
ann)
-1.2
3.5
2.3
2
1.8
2.2
1.2
spread to EM in terms of
Inflation (y/y)0.7
2.7
2.7
2.8
-0.1
0.3
2.2
1.7
Euro
zone
Real
GDP
(q/q
1.2
ann)
1.3
1.6
1.7
-0.6
-0.4
1.3
1.7
economic growth, and the Fed
Inflation (y/y)0.9
1.2
1
1.5
2.5
1.4
1.1
1.4
UK
Real
GDP
(q/q
2.3
ann)
3.1
3.1
3.3
0.2
1.4
2.8
2.5
tapering will cause more
Inflation (y/y)2.7
3
3
2.7
2.8
2.7
2.8
2.6
EM
Real
GDP
(q/q
5.2
ann)
5.2
5.2
5.6
4.9
4.7
5.3
5.7
difficulties in EM FX markets.
Inflation (y/y) 5
5.2
4.9
5
4.3
4.4
4.9
5.1
Source: Credit Suisse Research
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Rates 2014 Outlook
The US as the driving force: the timing of Fed tapering, US growth, and
inflation should be the key drivers for European yields.
US potential growth is expected to be higher than in Europe, and so US
yields are expected to rise versus Europe
Rates Strategy 2014 Forecasts
Fed Funds Rate
ECB Repo Rate
10Y US Treasuries
10Y German Bunds
10Y UK Gilts
1Q 2014
0-0.25
0.25
2.9
1.75
2.9
2Q 2014
0-0.25
0.25
3.05
1.85
2.95
3Q 2014
0-0.25
0.25
3.25
1.95
3.05
4Q 2014
0-0.25
0.25
3.35
2.1
3.15
Source: Credit Suisse Research
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FX 2014 Outlook
USD is likely to begin a multi-year rally as a result of be driven monetary
policy divergences: Fed is likely to begin a gradual process of
"normalizing" policy in January, while the ECB and the Bank of Japan
remain focused on stemming the resurgent deflationary threat.
Yen and AUD are likely to fall the most against the dollar.
"Twin-deficit" EM currencies are
likely to experience episodic
turbulence, as US monetary policy is
gradually "normalized."
FX Strategy Forecasts
EURUSD
USDJPY
GBPUSD
EURGBP
EURJPY
USDCHF
EURCHF
3m
1.3
95
1.557
0.835
123.5
0.946
1.23
12m
1.28
115
1.552
0.825
147.2
0.953
1.22
Source: Credit Suisse Research
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Equities 2014 Outlook
Forecasts: S&P500: 1960 (+8.5%), SX5E: 3600 (+16.4%), NKY: 18400
(+17.0%), FTSE: 7400 (+11.2%), MSCI EM: 1075 (+6.2%)
Equities are still cheap against bonds, even factoring in our bond team's
forecasts
Excess liquidity related to monetary easing remains supportive for equities
Funds flow and long-term positioning still look supportive for equities:
inflows into equity funds are close to an eight-month high, while bond
funds are experiencing outflows
Margins appear set to stay higher than investors expect.
Credit spreads appear set to remain tight, and credit marginally leads
equities.
Realised Volatility Scenarios for 2014: SPX 11%, SX5E 16.6%
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3 Investment Puzzles for 2014
The Return of Leverage in Financial Markets
Not a dislocation per se, but a
potential magnifier of current
market dislocations
NYSE Margin Buying since 1985
400,000
300,000
200,000
Margin buying on NYSE is at alltime high, posting one of the fastest
annual increases since 1985
100,000
0
1985
1989
1993
1997
2001
2005
2009
2013
Source: Credit Suisse Equity Derivatives Strategy
Deleveraging versus Equity Realised
60%
Vol
6M MSCI World Realised
High levels of margin debt are not
per se a predictor of a market
crash. However, high margin debt
tends to accelerate market
corrections
-60%
50%
40%
30%
20%
10%
0%
-40%
-20%
0%
20%
40%
60%
80%
% Change in NYSE Margin Debt
Source: Credit Suisse Equity Derivatives Strategy
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The Japanese “Anomaly”
BoJ assets are expected to grow to
60% of GDP by end 2014 – double
the size of the Fed, ECB and BoE,
making Japan a disproportionate
contributor to global liquidity after
Fed tapers
BoJ expansion has managed to
boost Japanese Growth,
contributing 0.9% of 2.5% growth in
2013, and pushing the Nikkei up
nearly 50% YTD
Central Banks’ Expansion since 2007
Source: Credit Suisse Equity Derivatives Strategy
3M Realised Vol Ratio, Japan vs Other
3.5
G3
NKY/SPX
3
JPYUSD/EURUSD
JGB/Treasuries
2.5
2
This was achieved at the cost of
cross-asset volatility even larger
than during the Fukushima incident
compared to the rest of the world
(3-sygma event)
1.5
1
0.5
0
2000
2002
2004
2006
2008
2010
2012
Source: Credit Suisse Equity Derivatives Strategy
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FX/Equity Correlation
Typically, Equity/FX correlation is
close to zero, or negative for most
open economies (UK or Eurozone)
Since 2007, the financial crisis
followed by Fed expansion, has led to
a general Equity/USD negative
correlation, leading to unusual
correlation levels for other
Equity/currency pairs.
FX/Equity Correlation since 2000
100%
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
NKY/JPY
SPX/JPY
SX5E/EUR
FTSE/GBP
Oct
Apr
Oct
Apr
Oct
Apr
Oct
Apr
Oct
Source: Credit Suisse Equity Derivatives Strategy
FX/Equity Correlation YTD
100%
80%
60%
This “new normal” has started
breaking down in Q3, and traditional
dynamics are expected to restore with
the Fed Tapering in 2014, adding risk
to European portfolios diversified with
USD
40%
20%
0%
-20%
-40%
-60%
Mar
Jun
Sep
Dec
NKY/JPY
SPX/JPY
SX5E/EUR
FTSE/GBP
Mar
Jun
Sep
Source: Credit Suisse Research
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