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Equity Derivatives Strategy Equity 2014 Review and Outlook 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 2 Another Great Moderation in Equity? The factors behind volatility compression 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? 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 1Y Implied and Realised Volatilities – Global Equity Benchmarks 60% 50% Average 1Y Implied Volatility Average Realised 40% 30% 20% 10% 0% 2003 2005 2007 2009 2011 2013 Source: Credit Suisse Equity Derivatives Strategy 4 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 Better corporate earnings prospects: − Record high margins − Sustained by lower interest charges, wage growth, taxes, and better regional diversification of earnings SX5E 1Y Implied Vol vs iTRAXX Europe 50% 45% 40% 35% 30% 25% 20% Hist. Since 2004 15% "Last" 10% 0 50 100 150 200 250 Source: Credit Suisse Equity Derivatives Strategy 5 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 − 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 Excess Liquidity vs PE Expansion Source: Credit Suisse Equity Research 6 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 −Investors Decreases hedging portfolios Long-term US Real Yields are returns looking on to either − Re-allocate to Equity − Allocate to alternative investments (Smart Beta, Emerging Markets Bonds, Alternative Risk Premia) 7 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 SX5E, S&P and Nikkei 5Y Skew 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 0.03 0.02 0.01 0.00 30-Dec-04 SX5E S&P 01-Jul-07 30-Dec-09 30-Jun-12 N225 Source: Credit Suisse Locus 8 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 government bond yieldsOutperf vs 10Y Treas. Yield Relative Flow tocorrelated Div Funds vsto Equity FundsS&P 500 Div Index Source: Credit Suisse Equity Research Source: Credit Suisse Equity Research 9 Volatility Supply and Demand in 2014 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 Alpha Availability Index Source: Credit Suisse Equity Derivatives Strategy 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 11 Volatility Hedge Funds 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 Source: Credit Suisse Equity Derivatives Strategy Cond. P&L of SPX Dispersion (100 60% vega) 6M MSCI World Realised 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 -60% 50% 40% 30% 20% 10% 0% -40% -20% 0% 20% 40% 60% 80% % Change in NYSE Margin Debt Source: Credit Suisse Equity Derivatives Strategy 12 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 US Pension Funds Deficit Source: Milliman 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 13 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 Vega Profile of 1Y DOI SX5E Put (bar 2000) Source: Credit Suisse Equity Derivatives Strategy SX5E, S&P, Nikkei 5Y Skew 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 0.03 0.02 0.01 0.00 30-Dec-04 SX5E S&P 01-Jul-07 30-Dec-09 30-Jun-12 N225 Source: Credit Suisse Locus 14 Credit Suisse Global Outlook 2014 Key Points 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 Fed Tapering: started in JGB purchase Global Growth 2014 Forecasts December (vs CS January 2014E Annual Average Q1 Q2 Q3 Q4 12 13E 14E 15E Forecast) leading to rally in Global Real GDP (q/q3.6 ann) 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 3.5 the dollar and higher rates DM Real GDP (q/q2.2 ann) 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 1.9 US Real GDP (q/q 2.5 ann) 2.7 3 3 2.8 1.7 2.6 2.8 EM under pressure: narrower Inflation (y/y)0.9 1.2 1.3 1.9 2.1 1.4 1.3 2.1 Japan Real GDP (q/q 3.1 ann) -1.2 3.5 2.3 2 1.8 2.2 1.2 spread to EM in terms of Inflation (y/y)0.7 2.7 2.7 2.8 -0.1 0.3 2.2 1.7 Euro zone Real GDP (q/q 1.2 ann) 1.3 1.6 1.7 -0.6 -0.4 1.3 1.7 economic growth, and the Fed Inflation (y/y)0.9 1.2 1 1.5 2.5 1.4 1.1 1.4 UK Real GDP (q/q 2.3 ann) 3.1 3.1 3.3 0.2 1.4 2.8 2.5 tapering will cause more Inflation (y/y)2.7 3 3 2.7 2.8 2.7 2.8 2.6 EM Real GDP (q/q 5.2 ann) 5.2 5.2 5.6 4.9 4.7 5.3 5.7 difficulties in EM FX markets. Inflation (y/y) 5 5.2 4.9 5 4.3 4.4 4.9 5.1 Source: Credit Suisse Research 16 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 Fed Funds Rate ECB Repo Rate 10Y US Treasuries 10Y German Bunds 10Y UK Gilts 1Q 2014 0-0.25 0.25 2.9 1.75 2.9 2Q 2014 0-0.25 0.25 3.05 1.85 2.95 3Q 2014 0-0.25 0.25 3.25 1.95 3.05 4Q 2014 0-0.25 0.25 3.35 2.1 3.15 Source: Credit Suisse Research 17 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. "Twin-deficit" EM currencies are likely to experience episodic turbulence, as US monetary policy is gradually "normalized." FX Strategy Forecasts EURUSD USDJPY GBPUSD EURGBP EURJPY USDCHF EURCHF 3m 1.3 95 1.557 0.835 123.5 0.946 1.23 12m 1.28 115 1.552 0.825 147.2 0.953 1.22 Source: Credit Suisse Research 18 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% 19 3 Investment Puzzles for 2014 The Return of Leverage in Financial Markets Not a dislocation per se, but a potential magnifier of current market dislocations NYSE Margin Buying since 1985 400,000 300,000 200,000 Margin buying on NYSE is at alltime high, posting one of the fastest annual increases since 1985 100,000 0 1985 1989 1993 1997 2001 2005 2009 2013 Source: Credit Suisse Equity Derivatives Strategy Deleveraging versus Equity Realised 60% Vol 6M MSCI World Realised High levels of margin debt are not per se a predictor of a market crash. However, high margin debt tends to accelerate market corrections -60% 50% 40% 30% 20% 10% 0% -40% -20% 0% 20% 40% 60% 80% % Change in NYSE Margin Debt Source: Credit Suisse Equity Derivatives Strategy 21 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 Central Banks’ Expansion since 2007 Source: Credit Suisse Equity Derivatives Strategy 3M Realised Vol Ratio, Japan vs Other 3.5 G3 NKY/SPX 3 JPYUSD/EURUSD JGB/Treasuries 2.5 2 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) 1.5 1 0.5 0 2000 2002 2004 2006 2008 2010 2012 Source: Credit Suisse Equity Derivatives Strategy 22 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. FX/Equity Correlation since 2000 100% 80% 60% 40% 20% 0% -20% -40% -60% -80% NKY/JPY SPX/JPY SX5E/EUR FTSE/GBP Oct Apr Oct Apr Oct Apr Oct Apr Oct Source: Credit Suisse Equity Derivatives Strategy FX/Equity Correlation YTD 100% 80% 60% 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 40% 20% 0% -20% -40% -60% Mar Jun Sep Dec NKY/JPY SPX/JPY SX5E/EUR FTSE/GBP Mar Jun Sep Source: Credit Suisse Research 23 Disclaimer This information has been issued by Credit Suisse Securities (Europe) Limited (“CS”), which is authorised and regulated by the Financial Services Authority for the conduct of investment business in the United Kingdom. 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