A decade since the U.S. subprime housing troubles morphed into a global financial crisis, market sentiment still seems fragile and it sometimes feels as if the scars have yet to fully heal. The U.S. has experienced one of slowest recoveries on record, feeding constant fears of a new recession around the corner. Along the way, each successive high in the U.S. equity market has been doubted.
Paradoxically, the lack of fear—as reflected in the VIX, the so-called “fear gauge”—is making investors fearful as equity market volatility plumbs new historical lows.
The low volatility debate needs to be kept in the context of some remarkable aspects of this economic backdrop. First, the slugglish recovery has meant eroding economic slack has taken years—and is still not over. Our work on economic cycles suggests the expansion’s remaining lifespan can be measured in years, not months. Second, economic growth is incredibly stable—some U.S. labor market indicators, such as total private hours worked, are the least volatile on records going back to the 1960s.
Having looked at more than a century of data, we find that low realized equity market volatility can last for years—and tends to overlap with subdued economic volatility, as we write in our Global macro outlook Learning to live with low vol. Our work on equity volatility patterns show there is no “normal” or “equilibrium” level. Volatility does not suddenly revert to a mean. Our regime framework shows that volatility periods are persistent: often low, sometimes high.
Does low volatility equate to widespread investor complacency? Not necessarily.
Complacency is perhaps not the best way to think about it. The widely cited Chicago Board Options Exchange (CBOE) VIX measure of implied volatility only looks at short-term options market pricing. VIX reflects low realized volatility. But a low VIX doesn’t mean markets are ignoring the risks of a sudden, sharp market decline.
Broader options market pricing better reflects such tail risk events. The CBOE also publishes a SKEW index to provide one such measure. The SKEW shows how much more investors are paying for downside protection (puts) relative to upside bets (calls) on a one-month horizon. In simplistic terms, the higher the SKEW, the pricier the downside protection. In August the SKEW jumped back near record high levels, showing that many investors remain skittish about a potential equity selloff. See the chart below.
Not so complacent
Sporadic outbreaks of volatility are bound to happen in this environment, with political and geopolitical risk lurking everywhere. Record VIX volume in mid-August reflected how VIX surges accelerate due to the popularity of volatility-selling strategies, exacerbating moves. But this burst of activity also shows there are other investors on the other side of this trade, profiting on their downside protection. It’s not a one-way street to higher equity volatility.
Volatility by itself doesn’t tell us much. We have to look at underlying vulnerabilities in the financial system, particularly any stealth leverage build-up. Bigger vulnerabilities and a more unstable macroeconomic environment could trigger sustained higher volatility. Yet higher market volatility alone is not necessarily dangerous. Our work shows there have only been two episodes where a bout of equity volatility did not coincide with higher economic volatility and a recession in the past three decades: 1987 and 1998. While those episodes felt systemic at the time and were treated as such, their impact on the economy barely registers. The leverage in those episodes did not damage the financial system in the same way as widespread banking failures in 2008 and beyond. That is why the overlapping periods of market and economic volatility are the most fraught with the potential to expose systemic threats.
By its nature, stealth leverage is hard to spot in real time, so vigilance is always needed. What reassures us now? The economic backdrop is stable, the banking sector is in much more solid shape thanks to the post-crisis regulatory overhaul and there are no obvious signs of major financial imbalances that could disrupt the flow of credit as in the aftermath of 2008. We believe the focus should be on potential vulnerabilities and leverage rather than on obsessing about low levels of market volatility.
Listen to Richard Turnill and Jeff Rosenberg talk about our midyear investment outlook on the inaugural episode of our podcast, The Bid.