Investment strategies linked to market volatility are contributing to the recent downturn in U.S. stock markets, with potential to hasten the drop if instability continues to rise. These volatility control funds, which adjust their equity holdings based on market stability, have been significant buyers during the S&P 500's climb to peak levels this year. However, with the index now experiencing a downturn exceeding 4% from its highs and the Cboe Volatility Index reaching its highest since October, these funds are shifting to sell mode.
Despite the S&P 500 maintaining a roughly 5% gain for the year, analysts, including those from Nomura, predict that heightened market fluctuations could lead to these funds offloading approximately $45 billion in stocks. This is based on the premise of the S&P 500 enduring average daily shifts of 1% in the forthcoming two weeks. According to Deutsche Bank strategist Parag Thatte, these funds currently hold above-average positions, indicating a potential scale-back in exposure.
Charlie McElligott of Nomura notes that volatility control funds have begun to reduce their equity investments, with about $16.2 billion already sold off in the past week. While this amount is minor compared to the S&P 500's $42 trillion market cap, the momentum-following nature of these funds can amplify stock price movements. Increases in market volatility could also prompt other, more sluggish investment strategies to start selling.
Recent market fluctuations follow a prolonged period of relative calm, fueled by signs of steady economic growth and anticipations of Federal Reserve rate cuts. However, expectations for such cuts are diminishing amid rising inflation concerns, exacerbated by increasing oil prices due to conflicts in the Middle East. Volatility is also on the rise in other sectors, including U.S. Treasuries and the foreign exchange market, indicating a broad-based reassessment of risk among investors.
So far, the sell-off triggered by volatility-control funds has been moderate due to the gradual nature of the S&P 500's decline. However, Barclays strategists warn that a significant unwinding of equity positions could occur if market volatility spikes, particularly if inflation continues to outpace expectations, potentially restraining the Federal Reserve's rate-cutting capabilities.
With volatility control funds reacting quickly to market changes, a more pronounced increase in volatility could also engage other strategies that use volatility as a trading signal, leading to further market pressure. McElligott suggests that commodity trading advisers (CTAs) might sell an additional $31 billion in equities if the S&P 500 drops another 2%. Upcoming corporate earnings reports and inflation data could serve as catalysts for these movements.
