"US Equities: Skewed Risks" — BNP's 2024 Volatility Outlook 👀

Key Insights from BNP Paribas' 2024 Equity & Volatility Outlook...

—all the critical takeaways covering US index volatility for the year ahead.

First- BNP's "Key Messages"

Margin disappointment to drive earnings downgrades: BNP expects to see earnings downgrades in H1 '24 driven by margin misses. "Given valuations are already rich (SPX 1yr fwd PE 19.5x 81st percentile in 30yr), earnings downgrades will likely translate to lower equities. We revise our 2024 base case for SPX to 4500. The revised target acknowledges that the Q4 move lower in rates and dovish messaging from the Fed were supportive for equities. However, for a bullish narrative to continue to play out in 2024, that also now needs to be accompanied by a rebound in earnings. Additionally we see positioning as having become increasingly stretched heading into year-end. Our newly introduced Equity Positioning Indicator (BNP US EPI) reads 86.5 vs just 15 at the start of 2023."

Skewed risks: BNP sees the risks in '24 as very asymmetrically skewed to the downside... "If we do see disinflation, rate cuts, and earnings reacceleration it could be risk-positive, but volatility-negative. This bullish consensus scenario lacks the same recalibration the market had post the Fed's pivot in Q4 2023. Instead, shocks to the consensus are much more likely to be on the downside. Risks from geopolitics, fundamentals, valuations and positioning all imply a fatter left tail for equities. However, one place where we see no evidence of a fat left tail is the options market. Implied volatility is at lows and skew is extremely flat. This leaves downside equity volatility at very low absolute levels and in our view attractive to own.

Avoid both extremes in rotation: There were two equity regimes in 2023. The first was an extreme lack of breadth that drove massive NDX outperformance, led by the Magnificent 7. The second was a "dash for trash" in Q4. Our outlook for 2024 suggests that investors avoid both of those extremes going forward. NDX looks vulnerable given very elevated valuations. And while the Magnificent 7 were largely immune to the rolling recession in industrial cyclical parts of the economy, we feel that they would be less insulated from a consumption slowdown or a spike in unemployment. For the RTY, we do see a fatter right tail in the case of an acceleration in growth. However, we also see risks that the "dash for trash" has overestimated the relief from anticipated Fed rate cuts, at a time when nominal GDP is rapidly decelerating and effective interest rates for corporates are still rising. Our preferred part of the market to be long is the body of the distribution - for example, equal-weight S&P500 (SPW). This avoids the tails that are either risky or too expensive and has an industrial cyclical bias versus the market-cap-weighted S&P500 (SPX). SPW is our preferred long and NDX our top US index short.

BNP Believes US Equity Positioning to be Extremely "Full"

US Equity Positioning Indicator: 2023 was a reminder of the importance of flows and positioning as a short-term market driver. The street entered the year defensively positioned (BNPP US EPI at 15 on 1 January). We then saw short-covering in January 2023. During the summer rally, there were large buying flows as the market traded to new YTD highs (BNPP US EPI peaked at 96 on 3 July). Through September and October, the market staged a 10% correction. Our indicator troughed (BNPP US EPI at 32 on 1 November) before the year’s final risk rally in Q4. We now head for Q1 2024 with the BNPP US EPI at 87, equities overbought and positioning looking stretched (see figures 1 and 2).

Negative asymmetry: The indicator consists of 7 sub-components, scored 0-100, equal weighted and percentile ranked. Forward returns on average in our back-test show better market performance when the indicator is at a low level when positioning is defensive. Forward returns are worse on average when the indicator is more elevated (see Figure 4). There are times (such as 2021) when the indicator can remain high for a sustained period. These are low-volatility regimes in which leverage, although already high, continues to increase. In this context, the skewness becomes important. Our back-test shows a fatter left tail to the distribution of forward returns when the indicator is high. When positioning is elevated (as it is currently), the market can shift quickly from a low-volatility grind higher to a more volatile sell-off.

BNP— Systematic Strategies have Re-Levered...

CTA and vol target leverage: Systematic strategies, CTAs and volatility target portfolios are back close to highs in terms of leverage. The low-vol regime and trend higher into year end have seen both adding risk, with a combined total of $60bn of US equities bought over the past month.

High leverage is often consistent with a low-volatility regime and the market trending higher. In a benign market scenario, we can continue to see modest daily incremental buying flows from systematic strategies. However, the outlook is very asymmetric. On the downside, in the event of a trigger for a spot correction and a volatility spike, the selling flow can be considerable. Our downside shock scenario shows $135bn of combined selling over a month.

...and what does BNP have to say about US Index Volatility dynamics?

Late-cycle exuberance

New lows in volatility: Equity volatility is at 5-year lows, only the 17th percentile in a 20-year range. The end of Fed tightening cycles often results in periods of very low volatility. These tend to give way to a much more volatile environment if and when the economic data deteriorates. In the case of weak data or a recession, Fed cutting cycles do little (at least at first) to dampen volatility.

We see the market as having started to move from a mid-cycle environment for volatility to one that more closely resembles late-cycle exuberance (Fig. 4). We define this as a regime in which short volatility trades become crowded and realized vol levels are very low. Despite low levels of implied, the even lower levels of realized continue to incentivize more volatility selling.

These periods of exuberance can persist for some time, but generally end with a more explosive move out of that regime. In our view, the macro, positioning and fundamental outlook seems more constructive for volatility than 2023, in particular on the downside.

Positioning: Gamma selling is self-fulfilling...

Gamma supply: Periods of very low realized volatility can be self-fulfilling. We expect to see further material gamma supply as we enter Q1 2024. This is likely to be even more the case if the market trades in a more range-bound fashion. When dealers are left very long gamma (particularly if the other counterparty does not delta hedge), it can have a very dampening effect on realized volatility. Our index gamma map shows the current dealer long gamma profile at $3bn. We have seen the lowest periods of SPX realized vol when the BNP Index gamma map has implied the highest levels of dealer long gamma.

A growing long gamma overhang should drive both a steepening of term structure and of skew, in our view. SPX term structure (1y/2m ATM) is currently at 1.41, the 99th percentile in 5 years. Although quite steep in absolute terms, the level is consistent with what our regression implies for such a low level of vol. Skew, however, stands out as still very flat relative to the level of volatility. If there is a dealer gamma overhang that disappears on the downside, it could suppress ATM vol while leaving the market more vulnerable to downside volatility.

Skewed risks: Fatter left tail...

Front-month upside: Skew is the standout variable when looking at vol surfaces. Normalized skew is at the 6th percentile in a 10-year range, reflecting low spot/vol correlation. The right tail of the realized distribution of returns has been much fatter in 2023. The average rolling 1m up move for equities (3.8%) is 1.5x that of the average down 1m move. SPX 1m ATM call is worth just 1.36%- almost 3x less than the average monthly up move for the past year. Despite the flat skew, as long as the market continues to trend higher, we will see the low absolute level of short-dated upside vol continue to reset higher.

Medium-term skew: For 2024 on the downside, vol and skew have not performed during 2023. We believe that can change, given the shift in macro regime. As the market more fully prices in deeper cuts and a benign disinflationary outlook, it will become harder for macro data to provide positive shocks. Benign disinflation, Fed rate-cutting and robust growth instead are a vol-negative regime. If we have a period of more range-bound trading in Q1 2024, that could see the demand for upside fade. In this scenario, we could see additional pressure on already-low ATM vol, but skew starting to re-steepen. Fundamentally, we see more risk of a higher realized vol on the downside and a fatter left tail to the realized distribution. Given the absolute low levels of vol, we see SPX 3-6m downside as offering compelling value for hedging.

If you've been reading our newsletter or following us on Twitter- you already know we agree.

While our long-term view holds that US index skew IS undergoing a regime change / flattening... we believe that process to be long-term with periodic corrections back to more "normal" levels before resuming trend. 

Why?

-It's the flows!

We go through actual persistent order flow in our VIP Mentorship- which you can learn about here. Our core assertion is that implied volatility & skewness are driven in the long run by supply & demand... as well as a broad calibration to the trailing realized distribution of returns. 

For very specific reasons discussed at length privately in our Discord & Mentorship... the trend at the moment is clearly towards a flatter equilibrium level of index skew.

We hope you enjoyed the outlook & our commentary ~ if you want to spot these contributing flows in real-time and chat daily about concepts like these with a bunch of highly competent traders (and me!)... join our Discord today and dive in!🍻 

If you are looking for a more in-depth, structured walk through of the current market structure... including options order flow, volatility dynamics... & of course— how to flip this all to your advantage-

...then check-in and put your name on the Waitlist for the next VIP Group Mentorship. 

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~ Carson