Nightmare Coming True for the Stock Bulls that Were Blindsided in Brexit Shock

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Global investors had best pray that their hedges prove themselves to be more reliable than the bookmakers did.

In a rout made worse by the mistimed stint of optimism preceding it, Friday around the world equities plummeted in waves of selling that increased with the prospect of the reality of the U.K. recession set in. In the United States, futures on the S&P 500 Index fell 5%, triggering trading curbs, while equities from Rome to Tokyo to Paris plunged more than 7%.

The selloff is equivalent to the worst market meltdowns of the past decade, rivaling the Aug. 24, 2015 crash, where $2.7 trillion disappeared from the global stocks in just 24 hours, and it was reminiscent of the rush of traders to exit the latter half of 2008. Everything that might go wrong did. Shares went up in the last week, surging on Thursday, in part on supposition speculators sussed out the U.K. results prior to being counted.

A New York-based money manager for Schroders, Neil Sutherland says, “The market had front-loaded a lot of the rally, which oversees $415 billion of assets globally. The expectation in pretty much all markets was that the ‘Remain’ camp would win. It was always going to be asymmetrical.”

British stocks

While most of the forecasters seeing less impact in the U.S. than what Europe was feeling, the cost to American investors could still be high, as Brexit’s passage unite a host of other pressures that have weighed on emotion. Profits are falling, while valuations are the highest they’ve been in a decade, and the U.S. reported the worst hiring since September 2010.

Needing hedges

Secession’s victory leave investors global as dependent on their hedges as any time since the January selloff that rattled the markets. Trading of options and derivatives has been rapid in instruments that gain when there is turbulence in the market, among them are futures on the CBOE Volatility Index.

The volume in VIX contracts was on average 122,007 a day this week, which is more than 40% above the 2016 rate before then. A spread watched by options traders to track demand for protective hedges – implied versus realize volatility on the S&P 500m, which was widened to a records recently even as shares continue to climb. As of 8:15 a.m. in New York, the VIX soared 40% to 24.14, when S&P 500 futures traded 3.5% lower.

Skew index

London stock exchange

The rush has affected most asset classes. A Bank of America Merrill Lynch gauge that tracks cross-market risk, hedging demand and investor flows surged more than 90% just three days earlier during this week, which is the most that’s been seen since the August stock rout. Since June the Bank of America Corp.’s Skew Index has more than doubled, which is the demand for protection from large swings in global equities and currencies.

A Miami-based hedge fund, Alexander Alternative Capital’s Chief investment officer Michael Corcelli says, “His firm started selling S&P 500 calls to fund purchasing of puts this year while snapping up iPath S&P 500 VIX Short-Term Futures ETN to protect from losses that they predict would grow to 10%.”

Corcelli continued saying, “I did not think this would have worked yesterday at 3 p.m. I felt stupid and questioned myself. So while everyone had a great day, I lost 23 bps,” he said by phone from New York. “I thought that the bet was a loss of premium until I settled in to watch some news tonight. Tomorrow we will make money.”

Strategists have been united in a view that if the EU should leave it would result in extreme short-term pain for global equities, even more so after the gains experienced this past week that sent MSCI’s worldwide stock measure up by 4%. Approximations of the battering in indexes from Britain’s FTSE 100 to the Euro Stoxx 50 range from 5% to 20% or more, are based on notes sent to clients in the last few weeks. On Friday, the regional measure sank 9.3%rcent, while U.K. shares lost 4.4%.

Rebound seen

Brexit nightmare

Before the vote happened, there were only a few that factored the prospect of secession into their forecasts. This month strategists were surveyed and they found is that a rebound is expected to 3,161 for the Euro Stoxx 50 by year-end. Still, the decision by Britain’s comes with great skepticism about the stimulus for the European Central Bank. There is subdued inflation in the region and analysts project a 1.7% decline in profits. The Euro Stoxx 50 had fallen 7% this year before Friday.

Dubravko Lakos-Bujas, from JPMorgan Chase & Co. and head of equity strategy and global quant research, wrote “In the US, a vote to leave the union could lead to a higher sell off by computer-driven funds whose signals are directly linked to volatility. Equity divestitures by these managers could reach $300 billion in the vote’s aftermath.”

Larger unknowns

On Wednesday, Lakos-Bujas wrote in a note, “The bigger unknowns are the second order effects which could show up through various potential channels,” “Geopolitical uncertainty around trade and regulatory framework is a risk as it could spill over into business sentiment. Financial contagion could materialize if the banking sector starts to see significant weakness and spreads into Eurozone periphery.”

Yianos Kontopoulos, a UBS analysts led by Amongst, had the grimmest views of anyone, “Blended predictions implied by risk models with a survey of the firm’s own strategists picking a point where shares become buys. In the worst-case scenario, the UBS team saw the Euro Stoxx 50 drop by up to 23%, with the FTSE 100 declining by as much as 19% and the S&P 500 falling 9%.
Kontopoulos’s team makes it clear that they are not trying to forecast how and where markets will trade right after such a big event.

On Tuesday, Kontopoulos’s team wrote, “There could be liquidity-driven dislocations, price spikes, and large reversals. Rather, we attempt to answer a slightly easier question: at what level would we buy or sell each key asset class upon a ‘Remain’ and a ‘Leave’ scenario?”

Want to learn some more about UK stocks? Read how Brexit strikes pound and when you should purchase the best of British stocks.

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