Market braced for more swings

Chicago Board Options Exchange volatility index close to its highest levels since 2012

INVESTORS in the US stock market endured another punishing bout of volatility in the past week with more likely in store this week, as hedge funds and speculators continue to adjust to a changing interest-rate landscape.

Last week featured one of the biggest daily losses and one of the biggest daily gains of the year, the same pattern as the prior week. The broad indexes finished near the flat line on the week, but the Chicago Board Options Exchange volatility index, which measures fear in the form of portfolio-protection costs, finished near its highest levels since 2012. Wall Street is braced for more wild swings.

What triggered the onset of the volatility, which brought the Dow Jones Industrial Average to a nadir that was nearly 7 per cent from its July peak during a 460-point sell-off on Wednesday? That mystery has gripped Wall Street like an Agatha Christie whodunnit. Was it the sluggish German economy? The global oil glut? Or even ISIS or Ebola?

One culprit is the dollar. According to this theory, the shock to markets from the Federal Reserve's shift to a hawkish stance was expressed as a sudden spike in the relative value of the dollar. That caught hedge funds and other institutional investors off- guard. As the dollar rapidly appreciated against other currencies in the second half of September, hedge funds scrambled to sell out of positions exposed to the exchange rate. As they tried to cut their losses on popular dollar bets, they were forced to sell out of other big holdings.

In late September, market watchers like Lorenzo Di Mattia, manager of Sibilla Global Fund, began commenting on sudden violent moves in junk bonds, a recent favourite of hedge funds. From there, the selling spread into other hedge fund staples like small-cap stocks, and, more recently, oil futures and energy stocks. According to this theory, the volatility is a chain reaction of selling as funds are forced to raise cash for "margin calls" and clients bailing out.

Another theory, propounded by portfolio managers at Alpha Capital Management in Austin, was that the Ebola scare had caused the abrupt plunge in stock prices. Ebola's devastating effects on West Africa might, at first glance, seem to have relatively minor impact on US share prices. But traders react to Ebola's spread because it's an "unquantifiable" risk, said Mr Di Mattia, of Sibilla Global Fund. There are the risks of the epidemic spreading from West Africa to other parts of the world; the risks that Ebola, like Sars, will slow international trade, however temporarily; and the risks that Ebola hysteria could slow consumer spending in the US even if an epidemic never breaks out here.

Elsewhere, German industrial production, the most important statistic for the eurozone economy, slowed by the largest increment since the Great Recession in September. Said analysts at brokerage Credit Suisse, in a research note: "The euro area and German economies have slowed, but are not in recession ... Reliable indicators do point to a slowdown in German manufacturing, in part driven by its hitherto successful capital goods sector. We'd attribute that to slower demand growth in Asia and a knock to exporters' confidence from the imposition of sanctions on Russia."

The glut of oil is a mixed blessing for the global economy. Saudi Arabia has insisted the Organization of Petroleum Exporting Countries should not cut production, but other members such as Libya are complaining of economic pressure from an oil price that's fallen more than 20 per cent to around US$80 a barrel. For retailers and airlines, however, the oil-price drop is a welcome development.

For now, the economy is picking up steam as proven by data last week. Weekly jobless claims fell to their lowest level in 14 years while industrial production in September ramped up by the largest increment in more than two years.

Last week, conglomerate General Electric reported surprisingly strong quarterly growth for its core industrial unit. Earnings in the third quarter are expected to grow 9.9 per cent, based on the average Wall Street estimate, according to analysts at Thomson Reuters. While revenue growth, a truer reflection of demand, is likely to be much slower, sales are gradually increasing, too.

If recent volatility storms in 2011 and 2012 are anything to go by, the major indexes will return to their summer peaks by the end of the year. But it could be a rocky ride, especially this week.

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