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SocGen: "Low Vol Can Misprice High Yield By Up To 30%"

Yesterday it was Bank of America, today's it's SocGen's turn.

As we've repeatedly stated in the past, not a day seems to pass without some broker, investor, sellside analyst or pundit (this website certainly included) opining on i) how low the Vix has fallen, ii) how much lower it will fall, and iii) how the inevitable surge will lead to unpleasant consequences.

Today, that distinction goes to one of our favorite SocGen analysts, Andrew Lapthorne, who observes the recent run up in global stocks (the MSCI World is now higher for 8 months in a row, its best run since 2003 and 4th longest monthly winning streak on record), and points out that "these long positive runs are not actually harbingers of impending doom; of the five winning runs over seven months or more for MSCI World since 1969, returns were still positive a year later. So there is little to fear from a run of gains per se."

It's not all rainbows and unicorns though, because as Lapthorne points out, such ‘winning' streaks help suppress risks, while volatility, implied or realised - for whatever reason remains very low. As the chart below shows, realised 60-day volatility on both the index and at the individual stock level is bouncing around its historical lows. Realised volatility is 40% lower than its historical average, while volatility on average stocks is significantly lower than it has been historically. Asset price confidence, Lapthorne says, is therefore at record highs.

"So why does all this matter", the SocGen strategist asks rhetorically, and answers:

Well again, low price volatility in itself does not predict much, but it can create mispricing. In particular, high confidence as to what an asset is worth can lead to underestimating the potential downside risks, which happens almost mechanically in high yield debt markets where asset volatility informs part of the pricing model. The implication is that high yield credit could be 30%+ mispriced as and when volatility moves back to average.

Meanwhile, headwinds are emerging, most notably in Europe where the common currency has continued its strong move upwards, rising a further 3.4% during July, leaving the currency 12% higher this year. This is good news for owners of euro-denominated assets but harder for euro-based investors who have seen the MSCI World decline 5% from its end-March high. According to SocGen, the strong euro is yet to really impact the latest earnings season, though it should be "manna from heaven" for US companies with overseas earnings.

Still, it is starting to be factored in price-wise - Germany was a notable decliner during July, with the DAX30 now down c. 6% from its recent peak 30 trading days ago.

In retrospect, if this is the most severe warning that one of the market's most prominent skeptics can muster, it is perhaps not surprising why everyone is now officially rushing into stocks, and as Schwab reported on its latest conference call, "new accounts are at levels we have not seen since the Internet boom of the late 1990s, up 34% over the first half of last year... cash levels for our clients had fallen to about 11.5% of assets overall, now, that's a level that we've only seen one time since the market began its recovery in the spring of 2009."

Perhaps the old saying that it is only when nobody can see any risks, that the real risks emerge, will be proven true once again...