Volatility Grips Nikkei 225 Index as 2016 Kicks Off to a Rocky Start

OREANDA-NEWS. Japanese equities, as represented by the benchmark Nikkei 225 Index, tanked by up to 15.8% in mid-January, before reversing by 6% to close down 9.8% month-to-date on 27 January. The dramatic dives and consecutive rebounds this month have resulted in one of the worst starts to a year for Japanese equities. If the Nikkei 225 Index closes January down by 9.8%, it would have the exact performance as in January 2009 – in the midst Global Financial Crisis.

Implied volatility of the Nikkei 225 Index spiked to peak of 39% in mid-January from 20% at the start of the year, driving daily average turnover in the SGX Nikkei 225 Index Futures to 158,585 contracts (US$12 billion in value), the highest turnover since June 2013 as investors turned to the futures market to manage risk exposures and to express directional views.

Nikkei 225 Index Implied Volatility and SGX Nikkei 225 Derivatives Volumes

Source: SGX & Bloomberg (data as of 27 January 2016)

The SGX Nikkei 225 Index Options turnover grew in tandem with the increased volatility. On 22 January, the underlying index dropped below a key psychological level of 16,500 resulting in renewed activity in SGX Nikkei 225 Index Options, with a single day aggregate option premium of US$250 million transacted. 

Oil Contagion Suspected of Infecting Japan Equities

In lieu of major changes to market fundamentals, analysts have named oil price contagion as the main driving force of recent volatility in Japanese equities. Sell-side traders have mentioned that oil-backed sovereign wealth funds have been placing large sales orders, and that the funds may be choosing to liquidate equity assets rather than comparatively less liquid investments such as real estate.

On Friday, 22 January, oil prices recovered to above $32 from below $30 the previous day, and a similar recovery was experienced in the Nikkei 225 Index which rebounded 5.8%.

SGX Nikkei 225 Index Futures and ICE Brent Crude Oil Futures Prices

Source: Bloomberg (data as of 27 January 2016)

The 30-day rolling correlation between ICE Brent Crude Futures and SGX Nikkei 225 Index Futures flipped from negative to positive after the U.S. Federal Reserve raised rates in mid-December, and increased over 90% in January 2016, signalling a potential temporary alignment in market expectations.

30-Day Correlation:
ICE Brent Crude Front Month Futures and SGX Nikkei 225 Index Front Month Futures

Source: Bloomberg (data as of 27 January 2016)

Speculation that Central Banks Will Bolster Markets

The recovery on 22 January, Friday, may have been triggered by the European Central Bank’s announcement that it may ramp up easing as soon as March.

The Bank of Japan is due to announce results of its meeting on monetary policy this Friday. Declining inflation expectations, potential contagion due to diving oil prices and the recent strengthening of the Japanese yen are increasing pressures on Governor Haruhiko Kuroda to introduce additional easing before Japan lapses into a cyclical bear market. 

As widely expected, the U.S. Federal Reserve kept its monetary policy stance unchanged in this week’s meeting, acknowledging global risks and emphasised that they will be “closely monitoring global economic and financial developments”. The consensus expectation from analysts remains that the Fed will hike at a slow and gradual pace this year.

Japan Equities Price/Earnings below Median

The Cyclically Adjusted Price/Earnings multiple (CAPE), is a valuation that is cyclically adjusted over the prior 10 years and allows for the ratio to be viewed in the context of multiple business cycles. As calculated by Research Affiliates, the CAPE for Japan stands at 25 as of December 2015, which is far lower than the median level of 38 (calculated over 46 years since 1969). In comparison, the U.S. economy’s CAPE ratio in the same period stands at 26, higher than its historical median level of 16.

The low CAPE for Japan with its 46 year historical median and taking into consideration that the same ratio for the U.S. market has yet to fall below its median may be a signal that Japan equities valuations are cheap. In addition, if the recent sell-off in Japanese equities is truly due to oil contagion and not a shift in economic fundamentals, it is possible that a recovery in oil price will have an upside impact on the Nikkei 225 Index.

SGX Nikkei 225 Index Derivatives

SGX offers a comprehensive suite of Japan-related equity derivatives to cater to the needs of investors, including the Yen Nikkei 225 Index Futures and Options, USD Nikkei 225 Index Futures, and the Nikkei Dividend Futures. The SGX Yen Nikkei 225 Index Futures is the dominant offshore centre for trading Nikkei 225 Index derivatives. SGX offers extended trading hours for the Nikkei 225 Index Futures and Options up until 2am Singapore time, covering the London close.

In addition, SGX’s Japan-related equity derivatives remain available for trading on all Japan holidays, with the exception of New Year’s Day (1 January). Margin discounts on spreads formed with other SGX derivatives allow for greater capital efficiency for investors that has views on multiple Asian markets. 

Cross-Product Margin Offsets

Source: SGX (data as of 26 January 2016)