A question facing most investors today is the outlook for equities, and more broadly market risk. This ties into the outlook for the COVID-19 recovery, inflation and various technical parameters (such as flows, positioning, volatility and bond-equity correlation). Recently,we have seen a number of strategists calling for a market correction or indicating equities are in a bubble. In the last few days, we have witnessed turmoil related to trading activity in small highly shorted stocks. Our outlooks for asset allocation as well as equities remain firmly positive.There are 3 main reasons for these outlooks: 1) equity positioning is low in a long-term historical context, and we expect it to increase; 2)we expect the COVID-19 pandemic to rapidly subside at the back of vaccines and population immunity (already started to happen); and 3) we expect monetary and fiscal support to remain in place, driving consumption, global trade and demand for goods, and supporting higher inflation. In that light, any market pullback, such as on driven by repositioning by a segment of the long-short community (and related to stocks of insignificant size), is a buying opportunity, in our view. Below we explain our views and highlight some longer-term risks and how to hedge them.
Positioning across risky asset classes, and in particular in equities and commodities, in a long-term historical context is low. Our analysis shows that equity positioning is in the 30th percentile relative to the past 15years, both for systematic and discretionary managers. There as on forth is is simple: market expectations of volatility and tail risk are still very high (e.g.,as indicated by VIX,variance convexity,etc.), and historically that has been the main impediment for institutional buying of equities. Figure1, below, shows the equity beta of global hedge funds as well as our model for equity exposure (percentile) of systematic investors–they are largely following (inverse) volatility, and currently there are no signs of exuberance in institutional equity positioning. Here,we also want to discuss the question that we often get: “how come data from prime broker xyz shows that exposure is high?” The reason is often combination of these factors: prime data tend to have a short history of 1-3years (and in the context of the global pandemic and trade war/manufacturing recession of past 3 years, indeed net positioning is above average). However, 2021 should be a transformative year of COVID recovery, and looking at a 1-3 year history is not sufficient. Also, many data sets from prime brokerage do not include index hedges and derivatives products used for hedging, and thus may overstate net portfolio exposure. The key variable for positioning is the level of volatility. We expect the VIX to decline into the mid-to-high teens and positioning, accordingly, to increase from the ~30th to~60th historical percentile. In fact, realized volatility has already declined significantly (S&P 500 realized volatility ~10 vs VIX ~25 is a near-record spread). Given the low levels of inflation over the past decade, global trade war, and recent pandemic, the exposure of investors to equities and inflation protecting assets such as commodities is also very low (as compared to pre-GFC era).
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David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
