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Calm Markets Inspire Fears Storm Is Coming -- WSJ

27 Jun 2017 6:32 am
By Ira Iosebashvili 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the US print edition of The Wall Street Journal (June 27, 2017).

Stock volatility is near an all-time low and corporate profits have bounced back from a year ago, but investors are increasingly moving to protect themselves from big swings in financial markets.

Long-term U.S. government bond yields, which move opposite to price, fell to fresh lows for this year on Monday, the latest sign of investors' skepticism about economic growth. Meanwhile, utility stocks, often a refuge for nervous investors, have rallied this year, with another move up Monday helping to lift the broader market.

Other signs of anxiety abound: A measure that shows expectations there will be a big move in Wall Street's fear gauge, the CBOE Volatility index or VIX, rose to an all-time high this month. The VIX -- which offers a reading on investor expectations for turbulence -- this month has been hovering near an all-time low. The cost of insuring against a drop in the S&P 500 has climbed steadily since the beginning of the year. And currencies typically considered havens, such as the Swiss franc, have appreciated against the dollar since last month.

So far this month, investors have pulled $235 million from the two largest exchange-traded funds that profit from declining volatility, on track to be the biggest monthly outflow since November, according to FactSet.

The moves illustrate a bind ensnaring many investors. Stocks have soared to records this year, even as anxiety mounts over a cluster of issues that could derail the rally. Those include fears that a mistimed interest-rate increase by the Federal Reserve could dent economic growth, an accelerating drop in oil prices could hurt wagers on emerging markets, or China's economy could slow, with consequences beyond its borders.

Although money managers are loath to sit out a market rally, many have opted to increase their allocations to investments that would take the edge off a sharp decline in markets.

Erik Knutzen, chief investment officer for multiasset-class portfolios at Neuberger Berman, which manages $267 billion, has recently trimmed his exposure to assets that have soared in price, such as U.S. large-capitalization stocks, concerned that lofty valuations could take a hit if there's a threat to global growth. Mr. Knutzen is also selling put options on stocks, allowing him to buffer his portfolio from a decline in equities while still maintaining market exposure.

"There's a lot of anxiety about where to put money to work," he said. "We know the VIX won't stay low forever."

Some investors worry the Fed's pace of interest-rate increases will further slow a U.S. recovery that appears to have shifted into low gear. While the Fed's decision earlier this month to raise rates was widely expected, many investors were surprised that Fed Chairwoman Janet Yellen gave little weight to a series of weak inflation readings and indicated the central bank remains on track to tighten monetary policy for a third time this year.

Stocks fell an average of 7.4% in the six months after the Fed raised rates during a quarter in which GDP growth was 1.2% or below, according to data from UBS Group AG that analyzes three decades of Fed policy.

Some wariness is already apparent in the bond market, several analysts said. The yield premium investors demand to hold the benchmark 10-year U.S. Treasury note relative to the two-year note shrank this month to the smallest since September, approaching a 2007 low. A falling premium is known as a flattening yield curve and typically happens when worries rise that economic momentum is slowing.

"The bond market is already pricing in a Fed policy mistake," said David Woo, head of global interest rates and foreign exchange at Bank of America Merrill Lynch.

While riskier assets such as emerging markets are rising on hopes that a global recovery is sparking long absent inflation, "the bond market believes that rates will go up and inflation...will get crushed," Mr. Woo said.

He is also worried that a recent drop in oil prices will rout investors from emerging-market trades that have delivered big gains this year. The Russian ruble, which tends to move with oil prices, is down about 3.7% this month. Mr. Woo is advising his clients to buy the Japanese yen, a popular haven for investors during turbulent times. The yen has strengthened around 2% from its May lows against the dollar.

Timothy Graf, head of macro strategy EMEA at State Street Global Markets, which manages $2.56 trillion, is using an options strategy that would benefit if a bout of uncertainty caused sharp declines in comparatively volatile major currencies such as the Australian and New Zealand dollars.

A Chinese economic slowdown is clients' top concern, according to a poll his firm recently conducted. Moody's Investors Service cut China's sovereign credit rating for the first time in nearly three decades last month, even as Beijing has intensified a campaign to rein in risky investment and financing practices that pose a threat to the world's second-largest economy.

Even though risky assets have lately performed well, "there is a desire to hedge," Mr. Graf said. "Investors are trying to guess where the next crisis will come from."

Gunjan Banerji and Asjylyn Loder contributed to this article.

Write to Ira Iosebashvili at ira.iosebashvili@wsj.com

(END) Dow Jones Newswires

June 27, 2017 02:32 ET (06:32 GMT)

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