Stocks Look Unpriced For A Re-Escalation In War

Authored by Michael Ball, Bloomberg macro strategist,

US stocks do not look adequately priced for a re-escalation in tensions in the Middle East.

Consternation from both the US and Iran continues, with the former insisting talks are ongoing and the latter denying anything of substance is taking place.

President Trump has taken to urging Iran to “get serious,” while speculation grows that a ground offensive is looking more likely.

None of this seems to be perturbing the US stock market too much. S&P 500 futures are down 0.8% this morning, while the index itself is less than 5% from its prewar level.

Even more notable has been the pricing of tail risks inferred through option prices.

Out-of-the-money put skew in the S&P 500 (puts struck at 90% of spot versus those at 95%) has fallen back down in recent weeks, suggesting that the implied probability of a deep decline has fallen relative to a smaller drop.

The implied probability for selloffs has risen, but not in a way that suggests a high likelihood of a much deeper decline.

The fall in put skew is a key reason why the VIX has not risen more.

If the tails were more expensive as deeper out-of-the-money hedging demand was greater, then the VIX would likely be higher.

It’s currently at 27, lower than the 35 it reached on March 9th.

The comparative phlegmatism of stocks stands in contrast to the oil market.

Call skew in Brent crude has not fallen back (see bottom panel in chart above), implying commodity traders see perhaps a less optimistic outcome.

Whether that is a longer war, or ongoing disruption to the Strait of Hormuz (including a changing of terms for using it), if oil traders are on the right lines, then it’s easy to see a world where deeper downside risk in stocks should be priced more expensively.