Investors seek cover as trade battles rattle world markets

LONDON (Reuters) - Investors have sharply increased their use of hedging strategies, signaling concerns that the intensifying trade battle between the United States and China might hit economies from Germany to South Korea.

Money managers say that mounting barriers to trade between the United States and trading partners — Washington’s latest proposal for tariffs on $675 billion of Chinese goods is expected to elicit a response from Beijing — is prompting them to look for ways to protect profits in the event equity markets take a dive after years of growth.

That includes bets against declines in equity indexes and currencies as well as dividends and bonds.

“Only now have trade war concerns grabbed the spotlight for investors after bubbling away in the background for most of this year, prompting the rush for such hedging trades,” said Gerard Fitzpatrick, London-based chief investment officer for Europe Middle East and Africa at Russell Investments, which has nearly $300 billion of assets under management.

Trade isn’t the only issue weighing on investors’ minds. European growth has lost steam, oil prices are near $80 a barrel while the U.S., European and many emerging central banks are tightening monetary policy.

And politics could exacerbate any downturn, with Germany’s coalition in uproar over migration, and Italy’s new government flirting with a big-spending, possibly eurosceptic, agenda.

Hedging strategies also carry risk, however, namely that an anticipated market fall does not materialize.

Despite rising concerns among investors, the world economy is on a strong footing, with the global economy expected to grow 3.9 percent this year and next, according to the International Monetary Fund.

While many investors are reducing their exposure to equities, most remain reluctant to completely move away from stocks. As a result, demand has risen for investment positions aimed at offsetting potential losses, according to money managers, market indicators and data.

That includes trades such as “put” options on certain indexes - allowing them to sell at a preset price if the index falls below a certain level in exchange for paying a premium - or short selling the bonds of highly indebted companies.

Short selling is when hedge funds and other investors borrow securities and sell them, betting the price will fall so they can buy them back later at a lower price for return to the lender.

Investors also appear to be seeking more options market protection against currency losses, especially on trade-sensitive currencies such as the Australian dollar or the Chinese yuan, via purchasing put options on these currencies in the $5.1 trillion a day foreign exchange markets.

“Some of these trades are an extension to what we have been seeing from earlier this year but there is no doubt that there is increased nervousness now reflected in markets,” said Eugene Philalithis, a portfolio manager at Fidelity International, which manages $2.4 trillion assets under management globally.

Shifts in the costs of derivatives indicate hedging demand has picked up since trade concerns intensified.

For instance, the cost of hedging against falls in Germany's DAX index .GDAXI, highly exposed to exports to the United States and China, has increased sharply in the past week, according to Mathilde Richardot, a derivatives strategist at BNP Paribas based in London.

The Euro Stoxx 50 Volatility Index skew - a measure that derivatives markets look at to gauge demand for protection against volatility spikes - hit an all-time high as investors bought protection against sharp drops in equity prices for July and August. Similar moves were seen in U.S. stocks. .SKEWX

Some market specialists say out-of-the-money put options are increasingly popular; they are typically cheaper and provide protection in the event of larger price drops.

Investors have also purchased options that hedge against a drop of 10 percent or more in U.S. indexes, according to UBS strategists.

Open interest - or the value of such options outstanding and a gauge of demand from investors - on put options on the S&P 500 index .SPX falling around 10 percent from current levels maturing in the next two weeks is far greater than on other options, according to Thomson Reuters data.

Such is the demand for such “crash insurance” that James Purcell, head of alternative and sustainable investments at UBS Global Wealth Management said they are advising clients to look at other markets such as Hong Kong and South Korea to hedge equity market downside risks.

Edmund Shing, head of global equity derivatives at BNP Paribas says “the whole point of insurance is you should buy it if it’s cheap.”

Such trades are attractively priced because volatility, despite the souring environment, remains low, a phenomenon some put down to central bank liquidity supporting asset prices.

A gauge of expected S&P500 volatility is half the level of highs hit in February .VIX.

For graphic on stock correlations indices and VIX June 28 click reut.rs/2N357gx

Interest by investors in dividend hedging is also on the rise. While bumper shareholder payouts alongside buybacks have driven much of the equity bonanza in recent years, logic dictates that any glitch in the corporate cycle will cause dividends to be cut.

Investors often buy dividend futures, or contracts that allow them to bet on companies’ future payouts.

But “puts” on Eurostoxx 50 dividend futures are drawing more interest, according to Societe Generale and BNP Paribas, banks that dominate Europe’s equity derivatives business.

When the global economy is doing well, companies are comfortable paying out dividends to their investors but at the first sign of market stress, companies want to conserve precious cash flow so “dividends suffer a lot more,” said Charles de Boissezon, deputy head of global asset allocation strategy at Societe Generale.

Once the preserve of hedge funds, mainstream asset managers and pension funds increasingly use dividend futures, he added.

The Euro Stoxx 50 dividend futures index .SX5EDFT, which aggregates dividend futures contracts, is down 2.1 percent year-to-date, after six consecutive years of gains, suggesting investors expect dividends to decline.

Away from derivatives, outright short interest in emerging market equities has picked up on concerns that this sector would be worst hit should a trade war break out. Short interest measures the number of short positions not yet closed out.

Short bets in emerging market equities scaled a post-crisis high of $110 billion in early June, with China, Hong Kong, Taiwan and New Zealand among the most shorted markets, according to data from IHS Markit.

Bond markets have not been spared. Investors have built a notional $55 billion of short positions in U.S. dollar-denominated investment-grade corporate debt, according to IHS Markit. Short positions are up $8 billion this year and rose more than $2.3 billion since the end of April, IHS Markit data shows.

High-grade bonds have performed poorly this year; this and the short bets are down to companies’ high debt levels — almost all U.S. sectors’ leverage ratios were above their 20-year average as of end-2017, Societe Generale estimates.

This makes companies vulnerable to rising borrowing costs as well as higher tariffs.

For graphic on US and HY debt click reut.rs/2tD3zBW

A trade war would darken the overall outlook but some currencies, including the Australian dollar or from emerging markets, are expected to suffer more than others.

Investors went long the dollar the week of June 18 against emerging currencies for the first time in eight months NETUSDEM=. Australia's dollar AUD=D3 is near 1-1/2 year lows as the country boasts China as its biggest trading partner.

Derivative markets suggest investors are increasingly risk averse.

Three-month risk reversals on the Australian dollar AUD3MRR=, a ratio of calls to puts, is near 2018 lows. A similar gauge on the Swiss franc CHF3MRR=, a perceived safe-haven in the currency markets, indicates bullish positions on the franc at near two-month highs.

For graphic on euro usd positions click reut.rs/2tCeueZ

For graphic on flattening yield curves click reut.rs/2IxiAKg

Reporting by Saikat Chatterjee and Helen Reid; editing by Sujata Rao and Cassell Bryan-Low

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