One day after covering its long-standing long dollar call (coincidentally, just one week after former Goldman COO Gary Cohn urged Trump to flip on his own “strong dollar” policy), Goldman has gotten even more cautious and in a note released this morning it warns that “Investors are increasingly concerned about an S&P drawdown.” Here’s why:
The 10% rise in the S&P index since the US election was catalysed by a surge in optimism surrounding US policy. While the hoped-for policy changes now appear less likely, ‘soft’ data have shown continued strength, leaving the S&P index hovering just under 2400 as investors wonder whether economic activity can catch up to sentiment and support another leg higher in asset prices. While opinions on that question remain split, what is clearer is that, as investors continue to wait for the global economy to ‘show me the activity’, they have become increasingly nervous about the prospect of a large, sharp S&P drawdown: the VIX index, which had remained around 12 through much of 2017Q1, now stands close to 15.
However, while the S&P is clearly long overdue for a correction, Goldman cautions that an even greater threat faces emerging markets because “EM assets have not faced a true test in 2017: a
large S&P drawdown and a spike in volatility and investor concern.” Some more thoughts on the potential spillover effects from a US correction on emerging markets from Goldman.
How concerned should EM investors be if the S&P were to see a large reversal of its post-election gains? On the one hand, the ongoing improvement in macro fundamentals has contributed to a surprising resilience of EM assets to a wide range of external shocks in recent months, including fluctuations in US policy perceptions (“Benchmarking the EM asset recovery post the ‘Trump Tantrum’“, Global Markets Daily, February 23, 2017), DM rates and commodity prices. More specifically, Exhibit 2 shows that, in 2017, both EM equity indices and EM currencies have been far less sensitive than usual to shifts in the S&P index.
Exhibit 3 makes clear, however, that EM assets have not faced a true test in 2017: a large S&P drawdown and a spike in volatility and investor concern (the upper-left tip of the S&P’s ‘volatility smile’). Indeed, it has been more than a year since the S&P has seen a 10% drawdown, and volatility (both realised and implied) remained near historical lows for much of 2017Q1. Each of these trends was supported by rising momentum in survey-based measures of activity that – even if ‘hard’ data were to pick up – would be difficult to match in the remainder of 2017.
If the market is forced to wait much longer for a follow-through in activity data, and the VIX continues to rise, EM investors should not be complacent: despite improving macro fundamentals, an S&P drawdown when the VIX index has reached high levels would likely be painful, especially given that investors have continued to build EM positioning. Exhibit 4 shows that the sensitivity of EM assets to the S&P index is, unsurprisingly, far higher when the VIX is elevated.
And with that we shift our attention to the market where we find, surprisingly, that the latest VIX slamdown was just unleashed, and the dollar is rising, making a mockery of yet another Goldman warning.