Equity 2014 Review and Outlook Equity Derivatives Strategy.

Equity 2014 Review and Outlook

Equity Derivatives Strategy

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Executive Summary

Volatility across asset classes and in particular in Equity is being dragged down by a mixture of fundamentals and a change in the structural demand for investment products that seem durable and may force a general re-allocation to Equity – although looming risks remain

Credit Suisse Research Outlook for 2014 confirms this trend, with modest growth, low inflation and diminishing potential, good Equity prospects, but potential risks centered on spillover effects of Central Bank policies

Fed Tapering will be the main event for 2014, however we identify a few other dislocations that could disrupt the markets in the coming months: the return of leverage, Japan’s expansionary monetary policy, Bond/Equity and FX Equity re-correlation

Another Great Moderation in Equity?

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The factors behind volatility compression

1Y Implied and Realised Volatilities – Global Equity Benchmarks

Source: Credit Suisse Equity Derivatives Strategy

The Great Moderation refers to the 2004/2006 period which saw sustained Equity performance along with record low volatility

Implied and realized volatility in global Equity markets have reached Great-Moderation lows, making Equity one of the best performing asset classes – Why?

2003 2005 2007 2009 2011 20130%

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60%Average 1Y Implied VolatilityAverage Realised

The conjunction of macro stabilization, good corporate earnings prospects and synchronized QE creates a bullish, volatility-suppressing environment

At the same time, record-low real yields force yield-starved investors to investigate alternative investments – often short volatility

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0 50 100 150 200 25010%

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Hist. Since 2004

"Last"

Macro are supportive of Credit and Equity

Macro stabilization in 2013:− Global growth of 2.9%, in line with 20Y average− Emerging Markets are the largest contributors to Growth

SX5E 1Y Implied Vol vs iTRAXX Europe


Better corporate earnings prospects:− Record high margins− Sustained by lower

interest charges, wage growth, taxes, and better regional diversification of earnings

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More QE and more synchronised QE

Low Central Bank balance sheet expansion in 2012 Synchronized QE in 2013:

− Fed: $85bn expansion in 2013 vs. $40bn in 2012

Excess Liquidity vs PE Expansion

Source: Credit Suisse Equity Research

− BoJ on track to double its balance sheet by 2014

− ECB under political pressure to do more

How Equity volatility is affected:− Excess liquidity supports

equity market valuations and lowers Equity Risk Premium

− Implicit Put on Equity reduces the need for hedges

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The challenge of Yield Compression

Investors have preferred the perceived security of “safe assets” despite earning negative real yields, while assets considered riskier (Equity, Corporate Credit) are yielding above historical average on reduced risk

Lower yields pose an unprecedented challenge for the Investor:−Increases value of future liabilities−Decreases returns on hedging portfolios

Long-term US Real Yields

Investors are looking to either−Re-allocate to Equity −Allocate to alternative

investments (Smart Beta, Emerging Markets Bonds, Alternative Risk Premia)

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Generate Yield through Alternative Risk Premia

Current low yield environment is not supportive for Equity participation products. Structured Product issuance has concentrated on yield products (e.g.: Auto-callables) which compress long-term vol and skew

30-Dec-04 01-J ul-07 30-Dec-09 30-J un-120.00

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SX5E S&P N225

Source: Credit Suisse Locus

Institutions have continued developing their pure volatility activity with one additional objective: yield extraction, while regulatory news flow decreased the demand for long-term volatility

SX5E, S&P and Nikkei 5Y Skew

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The “Smart Beta” Alternative: High Div Yield Smart Beta benchmarks are designed to provide superior

exposure to a given investment theme: for instance the EUROSTOXX Select Dividend 30 selects high yielding stocks and provides 5.5% div yield

Flows into High Dividend Yield funds have outpaced flows to all Equity funds since 2009

The performance of the High Dividend indices tends to be negatively correlated to government bond yieldsRelative Flow to Div Funds vs Equity

FundsS&P 500 Div Index Outperf vs 10Y Treas. Yield

Source: Credit Suisse Equity Research Source: Credit Suisse Equity Research

Volatility Supply and Demand in 2014

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Institutions/Fundamental Long Shorts

General Outlook:− To heck with hedging after last

year’s 30% market rally and disappointing performance in 2012

− Levered Delta: Long Shorts outperformed thanks to low correlation; more single stock directional option trades

2014 Trading Implications:− Return of interest for European

underlyings given better outlook for European equities

− Potentially more interest for vol premium capture in the US given expected modest performance

Alpha Availability Index


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Volatility Hedge Funds

General Outlook:− Volatility Hedge Funds as a

group (HFRX) posted their second best year on record due to performance of opportunistic short vol

− Volatility long short strategies recorded a 2.5% loss for the year because of resilient vol of vol

2014 Trading Implications:− Dispersion (1Y correl at 60)

has become statistically unattractive

− Short Vol still interesting trade (SPX 1Y Var at 19.9 vs expected 11% realised)

VIX vs Subsequent 1M Realised Vol


Cond. P&L of SPX Dispersion (100 vega)


-60% -40% -20% 0% 20% 40% 60% 80%0%

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Pension Funds

General Outlook:− Recent equity strength has

allowed funding shortfalls to narrow

− Interest rate increase in corporate segment and regulatory changes reduced the present value of liabilities

2014 Trading Implications:− Potential de-risking with

Equity markets at record highs− Little impact on equity

volatility as only 1% of pension plans actually hedge and typical put spread collar strategy has minimal vega impact

US Pension Funds Deficit

Source: Milliman

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Structured Products (Retail)

General Outlook:− Issuance complicated by low

level of interest rates and low level of equity volatility

− Typical product embeds going short a DOI put option in exchange for an annual coupon with autocollable feature

2014 Trading Implications:− Depressed long term implie

volatilities and skews− SX5E dividend and repo

dislocation, as short long term forward exposure is hedged with long futures

Vega Profile of 1Y DOI SX5E Put (bar 2000)


SX5E, S&P, Nikkei 5Y Skew

30-Dec-04 01-J ul-07 30-Dec-09 30-J un-120.00

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SX5E S&P N225

Source: Credit Suisse Locus

Credit Suisse Global Outlook 2014

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Key Points

Source: Credit Suisse Research

Global Growth 2014 Forecasts

Modest growth, low inflation and diminishing potential: the 2014 global economy looks to be the most orderly in many years on a stable triangle of.

Monetary policy in 2014 is likely to remain both highly stimulatory and highly innovative: the ECB could ease further through LTRO or negative deposit rate, BoJ could announce a 30% increase in the pace of monthly JGB purchase

Q1 Q2 Q3 Q4 12 13E 14E 15EGlobal Real GDP (q/q ann)3.6 3.4 3.8 4 3.1 2.9 3.7 3.9

Inflation (y/y) 3 3.3 3.1 3.4 3.1 2.8 3.2 3.5DM Real GDP (q/q ann)2.2 1.8 2.6 2.5 1.5 1.1 2.1 2.2

Inflation (y/y)1.1 1.5 1.6 1.9 1.9 1.3 1.5 1.9US Real GDP (q/q ann)2.5 2.7 3 3 2.8 1.7 2.6 2.8

Inflation (y/y)0.9 1.2 1.3 1.9 2.1 1.4 1.3 2.1Japan Real GDP (q/q ann)3.1 -1.2 3.5 2.3 2 1.8 2.2 1.2

Inflation (y/y)0.7 2.7 2.7 2.8 -0.1 0.3 2.2 1.7Euro zone Real GDP (q/q ann)1.2 1.3 1.6 1.7 -0.6 -0.4 1.3 1.7

Inflation (y/y)0.9 1.2 1 1.5 2.5 1.4 1.1 1.4UK Real GDP (q/q ann)2.3 3.1 3.1 3.3 0.2 1.4 2.8 2.5

Inflation (y/y)2.7 3 3 2.7 2.8 2.7 2.8 2.6EM Real GDP (q/q ann)5.2 5.2 5.2 5.6 4.9 4.7 5.3 5.7

Inflation (y/y) 5 5.2 4.9 5 4.3 4.4 4.9 5.1

2014E Annual Average

Fed Tapering: started in December (vs CS January Forecast) leading to rally in the dollar and higher rates

EM under pressure: narrower spread to EM in terms of economic growth, and the Fed tapering will cause more difficulties in EM FX markets.

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Rates 2014 Outlook

The US as the driving force: the timing of Fed tapering, US growth, and inflation should be the key drivers for European yields.

US potential growth is expected to be higher than in Europe, and so US yields are expected to rise versus Europe

Rates Strategy 2014 Forecasts


1Q 2014 2Q 2014 3Q 2014 4Q 2014Fed Funds Rate 0-0.25 0-0.25 0-0.25 0-0.25ECB Repo Rate 0.25 0.25 0.25 0.2510Y US Treasuries 2.9 3.05 3.25 3.3510Y German Bunds 1.75 1.85 1.95 2.110Y UK Gilts 2.9 2.95 3.05 3.15

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FX 2014 Outlook

USD is likely to begin a multi-year rally as a result of be driven monetary policy divergences: Fed is likely to begin a gradual process of "normalizing" policy in January, while the ECB and the Bank of Japan remain focused on stemming the resurgent deflationary threat.

Yen and AUD are likely to fall the most against the dollar.

3m 12mEURUSD 1.3 1.28USDJPY 95 115GBPUSD 1.557 1.552EURGBP 0.835 0.825EURJPY 123.5 147.2USDCHF 0.946 0.953EURCHF 1.23 1.22

FX Strategy Forecasts


"Twin-deficit" EM currencies are likely to experience episodic turbulence, as US monetary policy is gradually "normalized."

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Equities 2014 Outlook

Forecasts: S&P500: 1960 (+8.5%), SX5E: 3600 (+16.4%), NKY: 18400 (+17.0%), FTSE: 7400 (+11.2%), MSCI EM: 1075 (+6.2%)

Equities are still cheap against bonds, even factoring in our bond team's forecasts

Excess liquidity related to monetary easing remains supportive for equities

Funds flow and long-term positioning still look supportive for equities: inflows into equity funds are close to an eight-month high, while bond funds are experiencing outflows

Margins appear set to stay higher than investors expect. Credit spreads appear set to remain tight, and credit marginally

leads equities. Realised Volatility Scenarios for 2014: SPX 11%, SX5E 16.6%

3 Investment Puzzles for 2014

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The Return of Leverage in Financial Markets

Not a dislocation per se, but a potential magnifier of current market dislocations

Margin buying on NYSE is at all-time high, posting one of the fastest annual increases since 1985

High levels of margin debt are not per se a predictor of a market crash. However, high margin debt tends to accelerate market corrections

NYSE Margin Buying since 1985

Source: Credit Suisse Equity Derivatives Strategy1985 1989 1993 1997 2001 2005 2009 20130

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Deleveraging versus Equity Realised Vol


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The Japanese “Anomaly”

BoJ assets are expected to grow to 60% of GDP by end 2014 – double the size of the Fed, ECB and BoE, making Japan a disproportionate contributor to global liquidity after Fed tapers

BoJ expansion has managed to boost Japanese Growth, contributing 0.9% of 2.5% growth in 2013, and pushing the Nikkei up nearly 50% YTD

This was achieved at the cost of cross-asset volatility even larger than during the Fukushima incident compared to the rest of the world (3-sygma event)

Central Banks’ Expansion since 2007


3M Realised Vol Ratio, Japan vs Other G3


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3.5NKY/SPXJPYUSD/EURUSDJGB/Treasuries

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FX/Equity Correlation

Typically, Equity/FX correlation is close to zero, or negative for most open economies (UK or Eurozone)

Since 2007, the financial crisis followed by Fed expansion, has led to a general Equity/USD negative correlation, leading to unusual correlation levels for other Equity/currency pairs.

This “new normal” has started breaking down in Q3, and traditional dynamics are expected to restore with the Fed Tapering in 2014, adding risk to European portfolios diversified with USD

FX/Equity Correlation since 2000


FX/Equity Correlation YTD


Oct Apr Oct Apr Oct Apr Oct Apr Oct-80%

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NKY/JPYSPX/JPYSX5E/EURFTSE/GBP

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Equity 2014 Review and Outlook Equity Derivatives Strategy.

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