After more than a year of metronomic, almost tedious gains, volatility is back. Since the start of February equity volatility, as measured by the VIX Index, has averaged nearly 21. While still barely above the long-term average, the new regime represents a significant departure from 2017, when the VIX averaged barely 11.
For investors this raises three questions: why now, will it continue and what to do about it? Starting with the first question, the most common response is to blame Washington, namely concerns around trade and the potential for increased regulation of the big tech companies. My own view is that policy uncertainty is a headline, but not the culprit.
As discussed last August, the relationship between policy uncertainty and markets is weak. In addition, it is not clear that policy is all that uncertain right now (see the accompanying chart). While there are potentially serious issues surrounding U.S. trade policy, for the first time in years there is clarity over corporate taxes.
Instead of fixating on Washington, investors should focus on three more quantifiable factors:
1. High yield is slipping.
High yield spreads bottomed in late January, coincident to the peak in equity markets. Since then, high yield spreads have widened by approximately 40 basis points (bps, or 0.40%), the largest jump since last August. As discussed in previous blogs, high yield spreads are one of the best coincident indicators of equity volatility. When spreads are higher, volatility tends to follow.
2. Broader measures of financial conditions have also tightened.
Short-term spreads have also widened, with the U.S. Libor OIS spread, a measure of short-term credit conditions, more than doubling in recent months. Beyond spreads, the U.S. dollar is no longer declining and long-term interest rates rose by 50 bps in under two months. Bottom line: Financial conditions are getting tighter.
3. The economy is strong, but not as strong as some had hoped.
Economic releases are no longer beating expectations. Last week the Citi Economic Surprise Index for Major Economies turned negative for the first time since last fall. While global growth is solid, it is no longer surprising to the upside.
Given the determination of the Federal Reserve, as well as the European Central Bank, to continue to normalize monetary conditions, I would not expect financial conditions to get easier anytime soon. And while growth is solid, this is already reflected in both markets and expectations. For example, GDP estimates for 2018 have risen by 0.5% since October.
All of the above suggests higher volatility, particularly when compared to last year. Assuming this to be the case, investors may want to consider both a moderately lower equity weighting as well as a higher weight to quality stocks, i.e. those with high return on equity, earnings consistency and low leverage. While the bull market may not be over, it is unlikely to get easier from here.