It’s getting harder and harder to explain away subdued volatility in the face of a plethora of geopolitical land mines.
Even if you strip out Syria and North Korea (that is, even if we forget there’s i) a six-year-old bloody civil war going on that by proxy pits the US against Russia and Iran against Saudi Arabia and ii) a boy king in Pyongyang that seems to be far crazier than his father ever thought about being), we’re still looking at a semi-global populist backlash that, recent setbacks notwithstanding, has the potential to reshape how we think about Western democracy.
How is it that markets are so calm?
How is that Q1 was the calmest opening quarter to any year in history as measured by average VIX level?
How is it that credit spreads have traded in such a narrow range that the most seasoned of analysts are literally shouting that “this is the most boring year ever!!!”
Well, BofAML’s Barnaby Martin went looking for answers and to be sure, the bank’s approach to “explaining” things, is a testament to how hard you have to try when it comes to justifying the tranquility.
And as you’ll see below, in the end it all comes back to one thing.
Policy uncertainty was recently been at the highest levels we have ever experienced. However spreads have remained relatively tight and volatility was close to record low levels. The cash bond market is still trading in a tight range in the past couple of months and implied vols across a wide range of asset classes up to recently were close to the lows. Our analysis shows that this is a direct result of improving trends across a number of macro indicators, valuation attractiveness and positive surprise factors.
Policy uncertainty is not a necessary prerequisite for wider spreads and higher vols. We think that wider spreads and higher vols are a direct result of worsening trends in economic data and other macro indicators, when policy uncertainty is translated to economic uncertainty. QE tapering could potentially pose risks to the downside.
In chart 2, we employ a z-score analysis to illustrate the synchronization of the vol and spread markets. This has been a theme we have highlighted in our 2017 Year Ahead note, where we made the point that credit spreads are behaving like a vol product.
Why vols and spreads have been low. Why are vols and spreads staying relatively low, despite the rise in policy uncertainty and populism? We think the reason is improving trends across a plethora of macro and risk valuation indicators. An improvement in trend happened not only on a level basis, but we also note a decline in the volatility and dispersion that these metrics exhibit.
In charts 3 and 4 above, we present the strong correlation on patterns between (i) macro indicators uncertainty (US GDP volatility) and risk-assets volatility (VIX), and (ii) shifts on valuations trends (earnings revision ratio) and credit spreads (€-IG non-fins, EN00 index).
Assessing economic certainty. We have highlighted in the past that economic data have clearly bottomed out and have been strengthening in the past year (When rates move up…). We saw manufacturing PMIs across Europe but also globally pointing strongly to the upside. Note that this is an uptrend that is also characterised by a broad participation across countries and regions.
In order to assess the level of economic uncertainty we pool a broad range of macroeconomic, sentiment and valuation indicators (chart 5). We employ a z-score approach to assess the trends seen across these metrics. It is a blend of metrics that capture changes on trends on the level, the volatility and the dispersion (if applicable) of these indicators. Our analysis starts in 2000, based on quarterly data to align metrics of different frequencies.
Chart 6 is presenting the average z-score across all the 15 different metrics we use to assess economic data uncertainty levels. Interestingly we find that:
- Our economic uncertainly indicator exhibits 75% correlation to the trends seen in spreads for the euro-IG market (EN00 index), and 72% to the level of the vol market (VIX). In simple terms there is a clear connection between the level and trends that prevail on the economic uncertainty and the underlying credit spreads and volatility. The lower (higher) the economic data uncertainty, the tighter (wider) the credit spreads and the lower (higher) the implied vol in risk-assets.
- Currently the Economic Data Uncertainty z-score is at the second lowest reading ever since 2000.
Policy uncertainty vs economic certainty – who will win? Rising policy uncertainty has been the biggest theme so far this year. However, the recent results in the Dutch elections and the improvement in the French elections polls (towards a Macron win) have allowed investors to shift their focus to the economic data recovery. A clear attestation of that is the significant U-turn of investors’ sentiment in terms of what they fear. “Populism” has been rapidly brushed aside as investors’ biggest concern. Just 4% now view it as their top concern over the next year, a massive drop from 44% in February.
While policy uncertainty has reached the highest last month, economic uncertainty – as per our calculations – is at the second lowest reading in the past 18 years (chart 7). This clearly illustrates that economic data uncertainty is the real driver of risk aversion. However, the tipping point we think is the rising risk that economic policy uncertainty could ultimately result in economic data uncertainty.
Ok, fine. But BofAML does admit that all of this is subject to the same old caveat. Namely that no one knows what happens when $400 billion/quarter in central bank liquidity flow is cut off.
As Martin notes, the “tipping point could be magnified more especially when the central bank driven QE-put has reached its peak last month.”
And finally, the most important line of all: “…from here onwards we see the QE-put tailwind to become less supportive.”