By Mark Melin 

The most significant risk for equity markets is higher interest rates, a report from JPMorgan’s North American Quantitative and Derivatives Strategy team says. The April 24 French election and troubles with the Affordable Care Act in Congress, which the bank also sees as major risks, are but icing on the risk management cake that most investors appear to be ignoring. To hedge risk, the bank puts forth a long / short strategy as well as various volatility exposures.

Long / short hedge – JPMorgan notes abrupt change in Fed policy, looking at four rate hikes in 2017

With US volatility strangely low, JPMorgan’s March 15 “Volatility Review” report, authored by Bram Kaplan, Marko Kolanovic and Shawn Quigg, say now might be the time to take advantage.

The low volatility is odd from several perspectives.

First, the US Federal Reserve’s rate hike “came about relatively abruptly, as a series of FOMC committee member speeches shifted market expectations just roughly two weeks ahead of the meeting.” Volatility is by definition driven by surprise, and given the impact that raising interest rates – withdrawing stimulus that market participants at one point were dependent on – combining with an apparent abrupt change in policy, what might really be surprising is the lack of volatility.

JPMorgan economists are predicting four rate hikes in 2017, with an increasingly hawkish Federal Open Market Committee looking for three hikes in 2018. While this risk has yet to be priced into markets, that could change – particularly if it is coupled with political risk.

long / short

Political risks include French elections and Affordable Care Act passage

There are, of course, political concerns, with developments in France leading the charge.

Even though JPMorgan thinks populist Marine Le Pen doesn’t stand much chance in winning the election this fall, when the final round of presidential polling takes place, the next round could present a shock to the system.

Separately, if Le Pen wins and is able to pull France out of the euro currency, it could lead to banks rewriting or potentially paying out on many of their SWAPs contracts, an issue that UBS Global Macro Portfolio Manager Erin Browne appeared to touch on Friday in a CNBC interview. She argued that unlike Brexit or the election of Donald Trump in the US, a Le Pen victory and resulting French defection from the euro could lead to fundamentally damaging consequences.

It is not only the French election but the potential passage of an ACA replacement bill that investors may wish to hedge:

J.P. Morgan healthcare analyst Gary Taylor highlights the better than expected budgetary impact and worse than expected enrollment estimates, while acknowledging a rising probability of passage, which would be generally viewed as a negative for the industry given the higher than expected under/uninsured estimates. While a final version of the bill and its fundamental impacts are difficult to determine, House Speaker Paul Ryan continues to rally support for the bill. ACA reform is a major focus for the Trump administration, and the efforts of the GOP are a rising risk to the healthcare sector, particularly as the XLV continues to perform in line with the broader market. Furthermore, the unpredictability of Trump’s tweets and true intentions on drug pricing and healthcare reform continue to provide added headline risks and fundamental uncertainty for the sector.

There are numerous methods to hedge all these risks, and the well-known derivatives strategists look for bargains amid skewed gamma:

Buy May S&P 500 95% puts for 75bps or 95-90% put spreads for 45bps (the latter taking advantage of steep skew) indicatively—S&P 500 May ATM volatility is ~11%, low enough to justify holding some protection into this binary event, even though recent carry has been poor

Buy VIX April 14 strike calls for 1.45 points (or April futures outright @ 14.1) indicatively as a hedge against deterioration in the polls ahead of the first round of the French election—the max loss on the calls is the premium paid, but they could gain several times the premium in case of a panic ahead of the election (or significant market selloff for any other reason over the next five weeks)

But perhaps most innovative is their long / short strategy, specifically designed to hedge interest rate risk. The short end of the strategy bond-like sectors including Utilities, Telecoms, and already beaten down REITs, sectors which “underperform due to their declining yield relative to bonds and the typically high levels of debt in these sectors. On the long end, those sectors benefiting in a rising rate environment, include names in the Energy and Technology that “tended to outperform due to low levels of debt and the fact that oil prices tended to increase alongside rates.” Financials (ex-Real Estate) are also on the list of 25 long and 25 short names.

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