(Bloomberg) -- No more easy optimism.
After four months of cruising ahead, stocks are facing choppy waters. UBS Wealth Management on Friday advised its clients to buy protection against trade war-fueled volatility, which it says is here to stay. Nomura Holdings Inc. in turn warned that this week’s recovery in global equities could be short-lived and price swings will return in late May.
There are signs investors are listening. A record share of fund managers in a Bank of America survey said they have bought protection against a sharp drop in stocks, while Societe Generale SA and Maven Global noted that clients are actively searching for defensive instruments. The CBOE Volatility Index, or VIX, has surged in May, breaking its longest streak of declines in almost five years.
“We see an increased number of investors looking to protect against potential corrections as they see geopolitical risks increasing from potential trade wars and tariffs,” said Philippos Kassimatis, co-founder of Maven Global, a London-based hedging advisory firm. “There are definitely catalysts that can spook the market and create volatility in the next few months."
A series of tweets by U.S. President Donald Trump has reignited concerns about China trade talks, dealing a blow to this year’s global stock rally. While shares recouped some losses this week on hopes China will boost stimulus, the mood soured again on Friday. Without a strong trigger next week, the strength of the recovery will be put to the test, Nomura’s sentiment gauge signaled.
“We recommend that investors remain invested for long-term growth, and caution against taking drastic action based on trade headlines alone, while looking to protect against the continued volatility we expect,” said UBS strategists including Jon Gordon. They suggest defensive positions in the yen, the S&P 500 put option and underweight bets on the Australian dollar and Italian short-term government bonds.
However, the evidence of increased hedging remains mostly anecdotal. The ratio of open interest in calls versus put options on the CBOE Volatility Index -- bets that the VIX would jump -- spiked to a 2006 high in mid-April and has since sharply declined.
While investors are bracing for more volatility spikes, they’re not positioning for a prolonged equity downturn that could trigger a structural bump in volatility, said Kassimatis. Instead, he said, many clients maintain their long positions on stocks out of fear of missing out on future rallies.
When buying protection, traders should make sure their positions can be easily unwound in case of a future market retreat, said Charles de Boissezon, deputy head of asset allocation and equity strategy at SocGen.
“The liquidity risk is high, and we have seen a number of stress events over the past two years where it dried up quickly and painfully. Market players should ensure that their hedges really are liquid enough to be able to monetize them in case of sell-off,” said de Boissezon.
But liquidity concerns in defensive positions are less of a concern this time because the rally has lacked conviction all along, says Ankit Gheedia, a strategist at BNP Paribas. Equity funds have been bleeding cash for most of this year despite market gains, with net outflows amounting to about $135 billion so far in 2019, according to Bank of America and EPFR Global.
“Investors have been quite cautious since the start of the year, there is hardly any bull-market equivalent sentiment we observe in the market,” Gheedia said. “Hence the unwind of risk might not drive a liquidity event."
--With assistance from Yakob Peterseil and Sid Verma.
To contact the reporter on this story: Ksenia Galouchko in London at email@example.com
To contact the editors responsible for this story: Blaise Robinson at firstname.lastname@example.org, Namitha Jagadeesh, John Viljoen
©2019 Bloomberg L.P.