Investors Buy Protection Against Sharp Pullback at Highest Levels Ever

Stock investors who have suffered the worst month-to-date stock performance in nearly five decades have been bracing for more market upheaval. Over one-third of fund managers surveyed recently by Bank of America Merrill Lynch have taken out protection against a sharp fall in equity markets over the next three months, the highest level in survey history. "Investors are well-hedged but not positioned for a breakdown in trade talks," said Michael Harnett, chief investment strategist at BofAML. Mandy Xu, chief equity derivatives strategist at Credit Suisse, said in a note to clients yesterday, “Instead of selling out of stock exposure, investors are opting instead to pay up for hedges this time around,” according to The Wall Street Journal.

Unnerving Market Swings

The market's penchant for unnerving swings was illustrated as stocks rose in daily trading on Tuesday in response to comments from President Trump in several tweets that a trade truce could be reached without further tariff increases. Those stock gains, which could reverse quickly, have recouped only a small part of the market's losses since May 1 amid the escalation in the tariff war. On Monday alone, the S&P 500 Index (SPX) dropped by 2.4% as the CBOE Volatility Index (VIX) saw its biggest gain since October.

So it's no wonder that fund managers are anxious. Bank of America Merrill Lynch completed its monthly Global Fund Manager Survey between May 3 and 9 as the trade war began to escalate. Topping the list of possible tail risks for the markets was a trade war, voted their biggest concern by 37% of respondents, while 16% said a slowing China economy was the top tail risk. Meanwhile, 34% of respondents indicated that they are hedging against a sharp drop in stock prices, the highest in the survey's history.

Fund Managers’ Anxiety Rises

  • Record 34% hedging against sharp drop in stocks over next 3 months
  • Top tail risk: trade war (37% of respondents)
  • Other big tail risks: Chinese economy (16%), U.S. politics (12%)
  • High debt: 41% say corporations are overleveraged
  • Priority for corporate cash flow: near-record 46% want deleveraging
  • Global economic slowdown in next 12 months expected by 63%
  • But only 5% expect recession in 2019, only 33% before 2nd half of 2020

Source: Bank of America Merrill Lynch Global Fund Manager Survey, May 2019

Significance For Investors

The BofAML Global Fund Manager Survey for May 2019 was conducted between May 3 and May 9 as the trade war began to escalate. The panel included 250 investment managers worldwide who collectively oversee $687 billion of assets under management (AUM).

Investors' anxiety and desire to hedge have been spurred by the S&P 500 posting its worst start to the month of May since 1970, according to the Journal, which said traders are seeking to profit from surging anxiety and volatility by buying exchange-traded products (ETPs) that are designed to rise when velocity, as measured by the VIX, is up. The aggregate assets under management for such products has reached an all-time high in May, per data from FactSet Research Systems cited by the Journal.

Looking Ahead

In addition to developments in trade negotiations, retail earnings this week will be scrutinized for clues on how they will deal with higher U.S. tariffs, the Journal indicates. Companies that lack pricing power will have limited ability to pass along tariff-induced cost increases. The wild card is whether Trump and Xi, leaders of the world's two biggest economies, can strike a deal to calm the markets.

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