U.S. equity market volatility (vol) has been plumbing lows, stirring concern that a spike is overdue. We believe low realized vol can last for years, even with sporadic bursts, and it tends to overlap with periods of subdued macroeconomic vol. The chart below helps explain why.
We dug into data on U.S. equity market vol spanning more than a century to better understand its patterns. The chart shows realized (i.e., historical) volatility does not settle around a long-term average. Instead it is often low for long and sometimes high. We see regimes as a better framework for understanding vol versus expecting it to return to a “normal” level. History shows low vol regimes can last a long time.
What triggers a switch?
Low stock market vol only seems to keep getting lower. Yet we believe there are good reasons for vol to be subdued, as we write in our new Global macro outlook Learning to live with low vol. Looking back, we find low-vol regimes, when U.S. equity volatility averages 10%, can last for years. That means realized U.S. equity vol has historically stayed low for remarkably long periods of time. Sporadic spikes in volatility can occur but without causing a prolonged shift to a high-vol regime (22%, on average).
What triggers a switch? The economy is key. Jumps to high-vol market regimes tend to coincide with rising economic vol. Since 1985, U.S. equity and economic vol regimes have overlapped, apart from the 1987 equity plunge and 1998 market seizures. Those episodes were short-lived and did not feature high macro vol. What drives economic vol, or volatility in gross domestic product growth? It tends to be low in expansions, but surge around recessions. We see the current U.S.-led expansion lasting years.
Low vol by itself does not equate to complacency, in our view. The key question is whether it spurs build-ups of systemic vulnerabilities. We do not see systemic risk as high but are on watch for any stealth leverage build-up. The popularity of leveraged equity vol selling as a strategy to generate income may help suppress the VIX, a measure of expected vol for the S&P 500 that hit an all-time low in July. It could also lead to sharper unwinds. More broadly, we are seeing risks in pockets of credit but not in the broader market. We believe post-crisis financial regulation and periodic bursts of anxiety have kept asset froth in check. Combined with our view that the U.S. cycle has room to run, we believe this environment helps foster risk-taking. Read more market insights in my Weekly Commentary.
Listen to Richard Turnill and Jeff Rosenberg talk about BlackRock’s midyear investment outlook on the inaugural episode of our podcast, The Bid.