Volatility has been a hot topic in my household lately. To help explain why, I’d like to introduce you to Gator. I adopted him this spring after fostering him for a local rescue for about a year. It was a long winter, so we worked on his tricks with a slight twist by substituting market terms for regular commands. We just mastered “volatility”, which some people might refer to as “high ten.” Check out his skills!
Another phenomenon regarding volatility has captured the market’s attention recently. Expectations for volatility are low compared to historical standards, as measured by the CBOE Volatility Index (VIX) which is often referred to as the “fear gauge index”. The current VIX level of 12 indicates the market is expecting a daily standard deviation of approximately 0.75%, or that daily market movements will be less than 0.75% a little over two thirds of the time, and greater than 0.75% a little less than one third of the time. While periods of low market volatility aren’t unusual, what has puzzled investors is the continuation of low volatility in the presence of high policy uncertainty. Below is a chart that illustrates the VIX index (white line) and the Global Policy Uncertainty index (orange line) for the last 20 years. The two indicators usually trend in the same direction, so the recent divergence has received quite a bit of attention.
There are several explanations as to why this might be occurring. The first reason is that the synchronized global expansion, which started in the second half of 2016, has proven resilient thus far in 2017, even though political uncertainty is high (e.g. BREXIT negotiations and U.S. policy expectations). For the first time since the 2008 recession, most global economies are strengthening together, primarily because of a cyclical recovery in fundamentals such as manufacturing, trade, and commodity prices. Investors have already seen this return to trend-like global growth begin to translate into support for markets and current valuation levels as corporate earnings in the U.S. are near all-time highs and earnings momentum in the Eurozone and Japan have surprised to the upside.
Another potential reason for the risk and uncertainty divergence is the hand off from monetary policy to fiscal policy. As the Bank of International Settlements (BIS) noted in their latest annual report, markets have started to differentiate between sectors and countries in response to political and fiscal expectations as opposed to the “risk on” or “risk off” behavior that we had become over the last 8 when monetary policy was the primary driver of markets. We saw this new trend play out several times over the last year. The first example was the U.K. markets after the BREXIT referendum when export focused companies that would benefit from a weaker GBP were impacted less than their domestically focused peers. After the U.S. presidential election, infrastructure and high tax companies soared while importers lagged as markets priced in the potential for fiscal stimulus, tax reform, and trade reform. Although the election and referendum resulted in significant movements, market participants distinguished between winners and losers as opposed to extending flows into safe haven assets.
For the final explanation, we can turn to CBOE SKEW index. The SKEW index is based on out-of-the-money options which only generate a positive return for the buyer in the event of a large market movement. These movements are tail events if there is less than a 5%, or greater than two standard deviations, chance of occurring. When the prices of these options increase it signals that investors are more willing to pay for portfolio “insurance” and thus the market is pricing in a greater likelihood of a tail event. However, the heightened risk of a tail event wouldn’t be evident in the VIX as it is observing a different statistical moment and because of the fact that it is nearly impossible to assign a probability to a tail event. When comparing the SKEW index (white line) and the Global Policy Uncertainty index (orange line), we see that they have moved together recently.
To sum it up, when considering all of the pieces of data it appears that the market isn’t playing tricks or being complacent to risks because of the low implied volatility. It’s likely telling us that on average, risks are lower because of the improving economic fundamentals, but tail events might be more likely due to policy uncertainty and potential missteps. In times like this it is as important as ever to adhere to the prudent investor philosophy of staying invested in the appropriate allocation for your return goals and risk tolerance. APCM’s process of generating long-term capital market expectations incorporates both high and low volatility regimes so your portfolio was designed to withstand market turbulence when it invariably arises. As for Gator, with volatility out of the way, we’re going to work on “inflation”, or “beg”, next.
For more information about CBOE volatility indexes (including the VIX and SKEW) click here: https://www.cboe.com/products/vix-index-volatility/volatility-indexes
For more information about the Global Policy Uncertainty index click here: http://www.policyuncertainty.com/global_monthly.html
For the annual BIS Report click here: http://www.bis.org/publ/arpdf/ar2017e.htm
For more information about adopting a rescue through Anchorage Animal Care and Control or fostering with a partner rescue organization in Anchorage click here: https://www.muni.org/Departments/health/Admin/animal_control/Pages/default.aspx