Merrill Lynch expects more volatility as cheap funding dries up

PUBLISHED : Monday, 07 February, 2005, 12:00am
UPDATED : Monday, 07 February, 2005, 12:00am

Since the start of this year, Hong Kong has been plagued by worries that the 'hot money' that pushed stocks higher in the final months of last year will begin to flood - rather than trickle - out of the market as the US dollar rebounds.

Now, Merrill Lynch is warning that the cheap funding that has poured into global equity markets from proprietary trading desks, hedge funds and private equity houses since 2001 is about to dry up, too. And, as a result, implied equity volatility is set to rise.

'When risk capital withdraws, riskier investments are liquidated first. Asia may therefore be at the forefront of any volatility rise, but the bottom is likely at least nine months away,' Merrill analysts Arik Reiss, Tony Lee and William Chan argued in a recent report.

However, investors should position themselves for this scenario now by buying long-dated volatility (two years or more) and be prepared to sell short-dated volatility (less than six months) on spikes, they recommended.

Implied volatility is essentially a yield paid to investors for providing risk capital to the market and can be compared to the bond yield paid to fixed-income investors. Yields fall when there is plenty of risk capital in the market.

As investment banks and hedge funds borrowed money mainly from the short end of the yield curve, three-month US Libor was a good indicator of the availability of risk capital, the analysts said.

Their study shows that periods of rapid change in interest rates lead the VIX index - which tracks the one-month implied volatility on the S&P 500 Index - by two to three years.

With three-month Libor having hit the trough in April last year, the bottom of the current volatility downward trend should fall in October this year.

However, they said the VIX was not expected to fall substantially between now and then and projected the trough at a mean level of 11 points against a low of 11.23 in recent months.

Low volatility does not preclude short-term upward spikes but, at current levels, any shock to the market will be immediately washed over with risk capital and is unlikely to persist for more than a few weeks.

'It is therefore reasonable to view any such spikes which may occur over the next nine months as selling opportunities,' the analysts said, noting the February 28 Indian budget, the People's Congress in China early next month and political tensions involving North Korea or between China and Taiwan as potential triggers for market shocks.

'Buying volatility ahead of events such as those in February and March may sound tempting, but it is a much riskier proposition than simply selling volatility when the spike occurs,' they warned.

korean rally to go on

The renewed inflow of domestic money into Korean equities over the past two months, as well as the return of foreign investors as net buyers last month, have been a major positive surprise for the market, but the rally is unlikely to be over yet, ABN Amro's Ben Rudd says.

'We don't believe it pays to stay in the way of strong local liquidity and, while 940 in the [Korea Composite Index] offers strong technical resistance, further upside could be in the cards, especially for small and mid-cap stocks, if local funds and retail investors continue to buy,' Mr Rudd said in a recent report.

The index closed at 933.55 last Friday after gaining 1.29 per cent on the week.

Domestic brokers are obvious winners from increased local activity.

Foreign investors are still underweight on these stocks relative to the MSCI Korea benchmark and may look to cover their positions if momentum is sustained.

LG Investment Securities offers the best combination in terms of attractive valuations, under-ownership by foreign investors and being a market laggard, the report said.

Small-caps such as Korean Air and Insun ENT, both relatively small and therefore more likely to catch the attention of domestic investors, should also benefit.

However, investors needed to watch the liquidity situation closely to determine the direction for the broader market, Mr Rudd warned.

A rising won forward premium would be an important early sign that foreign investors are reducing their won exposure.

Another indicator would be a drop in bond yields, following a sharp rise since the beginning of this year, as it would suggest local funds were moving their assets back to bonds.