Warning of equity sell-off as investors lulled into 'false sense of security'

Little fear in the equity market

Tom Eckett
clock • 2 min read

ETF Securities has cautioned US President Donald Trump's promises of fiscal expansion and corporate tax cuts have made equity markets "too complacent" and a potential "sell-off" is increasingly likely.

In a report entitled VIX and tax promises lulling investors into false sense of security, James Butterfill (pictured) head of research and investment strategy at ETF Securities, said there was little fear in the market, which is reflected in the CBOE Volatility index (VIX) remaining "exceptionally low", and equity markets such as the S&P 500 and Dow Jones hitting record levels. 

This, he said, is a result of investors expecting President Trump to deliver on his controversial policies such as injecting a $1trn fiscal boost into the economy through infrastructure projects, cutting corporate tax, repealing the Dodd-Frank Act and repatriating offshore money.

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However, Butterfill warned the recent lack of clarity from the Trump administration, and the potential for the Federal Reserve to raise interest rates three times this year could spark a sell-off in equities. 

He said: "We believe equity markets are becoming too complacent; valuations are high at a time when margins are likely to be squeezed further, while many promised tax cuts may not come to fruition this year. 

"Furthermore, we believe the VIX is lulling some investors into a false sense of security when holding equities. These factors leave equity markets vulnerable to a sell-off in the event of further interest rate rises and continued lack of clarity from the US political administration."

With the VIX averaging 11.2 this year compared to the long-term average of 19.6, Butterfill said it was "puzzling" the index had not taken into account political risk in Europe and the US. 

He also pointed to the unwinding of quantitative easing across developed markets and the bubbles this had created in asset classes as another factor which had not been reflected in the VIX. 

In addition, the report said investors are taking record net short positions and moving into riskier assets, as a result of "a perception of low risk".

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It said: "We believe the VIX is artificially low because of Commodity Futures Trading Commission (CFTC) positioning; while being volatile, it shows investors are close to the largest net short position in history.

"Perversely, low equity volatility could be a factor driving the Fed to raise interest rates in March, but higher rates could prompt a disorderly unwind of this short positioning given that it is so extended."

To understand why the VIX was low and to find a more accurate reading, ETF Securities created a model combining the Global Financial Stress index (GFSI) and the US Economic Policy Uncertainty index. 

It found the model closely correlated with the VIX between 2001 and 2014. 

However, a wide deviation occurred after this date, with ETF Securities suggesting the VIX should be nearer 20 than its current level of 11.4. 

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