“The only thing we have to fear is fear itself,” said Franklin D Roosevelt at his inauguration as US President in 1933.
I think “the only thing we have to fear is the fear index itself” is a better description of where investors are at right now.
It’s been a wild ride on Wall Street and beyond of the past week – the worst in two years for the S&P 500 – with the volatility causing many to ask if the bubble has burst and the equities bull market is over.
Instead, I believe the unusually sharp burst of volatility is largely the result of products and asset allocation strategies linked to the VIX, the so-called “fear index”, rather than any major re-assessment of the fundamental outlook.
To be sure, investors are right to be more worried than before about inflationary pressures arising from improved global economic conditions, the associated upward revision on the future path of interest rates and how that in turn impacts the valuation of share markets.
However, I would suggest that these expectations haven’t changed anywhere near as rapidly as market prices. Investment products linked to the VIX appear to have amplified the recent market adjustment.
And those that are not, such as fixed income and currency markets, experienced much more orderly changes.
The VIX measures the stock market's expectation of volatility implied by the price of option contracts on the S&P 500 index. Options enable investors to insure against large moves in the share market. When investor uncertainty rises, the share market becomes more volatile, the price of insurance through option contracts increases, and so the VIX index rises. The VIX index spikes at times of markets crisis. Hence the “fear index” moniker.
Initially the VIX was simply designed to provide a measure of expectations of volatility for the US share market. However, over time many derivative instruments and exchange traded products were developed that allowed investors to bet on the performance of volatility itself.
This has introduced the possibility of a destabilising feedback loop because there is often a requirement for these funds to quickly sell market exposure in response to a rise in volatility. This action can, in turn, push VIX even higher. That appears to have been the case this past week.
The following chart displays the VIX index over the past five years:
VIX (CBOE Market Volatility Index)
The growth in popularity of these volatility-linked products has been due to their strong track record in a world where investors are searching for high income with low risk.
The provision of insurance can be a profitable venture, especially if there is a strong demand and high insurance premiums as was the case for financial insurance in the aftermath of the Global Financial Crisis. And with investors believing that central banks were deliberately trying to suppress volatility, the VIX index was pushed down to historical lows, boosting the performance of these products.
However, more recently, given the growth in the supply of this insurance and the much-reduced premiums for its provision, these products were priced for disappointment and were susceptible to any surprise that pushed VIX higher.
A modest improvement reported last week on the outlook for wages and its impact on interest rate expectations produced an increase in fundamental share market risk. This appears to have triggered a risk cascade producing catastrophic losses in these products and several have been closed by their sponsors.
That probably doesn’t quite represent the end of this episode because it is widely known that there is also a large amount of institutional money whose asset allocation depends on the level of equity volatility. These strategies tend to target an overall level of realised portfolio volatility so they systematically sell equities when volatility increases and buy when volatility decreases.
Given the extremely low level of volatility prevailing at the start on the year, these strategies will currently be at the top end of their permitted range of equity exposure. I’d expect their portfolio managers will quite likely be required to sell some equities in the weeks ahead because volatility is unlikely to fall back to very low levels any time soon.
Given that, many other investors may sit back waiting for evidence that these trades have cleared the market before they step back into their own discretionary strategies.
A few years ago, we did experience a few spikes in the VIX index related to uncertainty about economic developments in China. These episodes were short lived and market volatility quickly retraced to very low levels because investors were convinced central banks would continue to protect asset prices.
The difference now is that economic conditions have improved, and unconventional monetary policy is beginning to be withdrawn. So central banks may have a higher tolerance for some asset market volatility. In the language of the option markets “the strike price for the central bank put is now further out of the money”.
Does any of this alter our assessment of the market outlook? Not really. We have, for some time, been anticipating a moderate increase in volatility as monetary policy shifts to a less accommodative phase.
Importantly, I don’t interpret the recent developments as the market signalling a rise in the likelihood of an economic recession over the next 18 months, even if there is a modest tightening of credit conditions. Nor do I believe that many businesses will alter their investment plans in light of this bout of extreme market volatility.
In a few months’ time, I expect that the debate in markets will again focus on critical fundamental issues - the outlook for growth and inflation, the trajectory of cash rates, asset market valuations, as well as any unfolding geo-political developments.
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