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In the Market - February 2010
Feb 15, 2010
China Risk
After a broad liquidity fuelled 2009 rally, global markets are facing their first test of the year with increasing sovereign risk and fears of Chinese slowdown. Systemic warning signals have starting to flash across major asset classes.
We will take a quantitative view of Chinese equities risk, focusing on three basic market indicators: volatility, VaR outliers, and correlations from 20 April 2005 to 12 Feb 2010.1
Chart 1 shows daily 95% Confidence VaR bands for the FTSE/Xinhua China 25 Index (FXI). After ending 2009 at a pre-crisis low not seen since 2006, VaR has risen by over 50% over the last month but remains at moderate historical levels.
Chart 1 - 95% Confidence Level Daily VaR Backtesting Chart (.94 decay)
Chart 2 plots the 100 day moving average of 95% confidence daily downside VaR outliers against FXI levels. After an unusually long stretch without downside shocks until August 29, 2009, outliers have risen to 9%, with an alarming clustering of 3 outliers over the last 3 weeks alone. Outliers are a key early warning signal for potential regime shift, and the chart below shows how outliers have often preceded major market corrections.2
Chart 2 - FTSE/Xinhua China 25 Index (FXI) vs. VaR outliers (95% confidence, .94 decay)
Correlations between Chinese and global equities are also on the rise. Chart 3 shows FXI's 100 day correlation with S&P Financials (XLF) vs VaR. The spike from 55% in Oct to 76% in December brings correlations close to crisis levels (maximum correlation was 78%). Notice also the general uptrend in correlation since 2005, indicating more coupled markets.
Chart 3 - FXI and XLI Daily VaR vs Correlation
Looking at broader market conditions, the recent global market tremor and flight into USD points to an escalating chance of Nouriel Roubini's "Mother of all Carry Trades Faces an Inevitable Bust" scenario materializing.
From a historical perspective, credit defaults often peak after recessions end,3 and banking crises commonly morph into broader debt crises.4. It looks like the Chinese Year of the Tiger could become a turbulent one, with significant increases in volatility compared to today's relatively moderate levels. Be wary of short gamma & volatility strategies generally, and selective with fixed income due to asymmetric downside of credit and interest rate risk (i.e., long credit = short crash puts).
1 for a well researched fundamental view, please see "China's Investment Boom: the Great Leap into the Unknown" by Pivot Capital, Aug 21, 2009
2 active risk taking institutions like JPM and GS will always review trading strategies after observing daily outliers. This implies that outliers are important from behavioral perspective too, as they can trigger a trading exit
3 See Ed Altman's "Current Conditions in Global Credit Markets," from the May 2009 RiskMetrics NY client conference.
4 See Reinhart Rogoff's "The Aftermath of Financial Crises" (2008)