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We are particularly concerned with how market sentiment may respond to China’s growth slowdown, topping-out of EM growth indicators, heavy real money positioning, and the widening in credit spreads in 2H.
Elsewhere, in isolation, we’ve been quite constructive on Asian equities and reckon that the fundamental risks have diminished post the political events this quarter (Chinese National Congress, Japanese elections etc).
However, they are concerned about valuations in the US and the “bull market in everything”, and believe that the positive outlook on Asian equities could be derailed by draw-downs in the US. USD-EM spot FX rates should be upwardly biased, and the bulk of total return performance in 2018.
In an effort to ascertain the sensitivity of Asian equities to severe historical draw-downs in US equities, it is looked at previous such episodes of larger than 20% draw-downs.
They present results across country indices and sectors, but to summarize, Taiwan saw the most frequent underperformance, closely followed by Singapore and Korea.
The maximum draw-downs for TWSE and S&P500 is observed since 1997 below (local currency terms) and it is found that TWSE has consistently seen quicker and more intense draw-downs than the S&P500 despite having comparable volatilities.
OTC outlook and Hedging Strategies:
It has been demonstrated in the above chart that the 6-month ATM implied volatility of various Asian indices against the statistic from our Asia equity strategy team’s analysis (% of the time an index has underperformed the S&P 500 in 20% or larger draw-downs). We find that Korea and Taiwan screen as the cheapest volatilities to own.
Relative value trades:
Long INR and IDR vs short KRW and TWD
Long CNH-TWD.
Options trading strategy:
It is recommended to hedge against a wider equity sell-off by buying TWSE downside options, add longs in TWSE Jun18 10000 strike put for 164 TWD.
The sensitivity of Taiwanese equities to any negative re-pricing in global growth, a downturn in the global tech cycle and any escalation in North Korean risks make them ideal as a risk-off hedge for equities.
The low volatility makes the case even more compelling. We recommend buying a 6-month OTM put on the Taiwan Stock Exchange Weighted Index (TWSE) to position for any downside in equities.
Risks: the total loss on the option strategy is limited to the premium paid up-front.
