Volatility has become the market’s perpetual topic du jour (does it make sense to use “perpetual” and “du jour” in the same sentence? Not sure on that).
Suppressed vol has become ubiquitous. And the amusing thing about ubiquity is that it has a way of making everyone think they’re entitled to have an opinion on whatever it is that’s ubiquitous. That’s certainly the case with volatility – these days, everyone who’s bought themselves some VXX or XIV lately thinks they’re Rocky Fishman.
That’s the (black) magic of VIX ETPs. Hordes of retail investors have been transformed virtually overnight into futures traders much the same way as the rampant proliferation of margin debt in early 2015 helped turn every bored housewife in China into a leveraged Shenzhen day trader.
This dynamic has created a veritable cacophony of explanations as to why equity vol is so low.
If you cut through the noise, it’s probably some combination of plunging stock and sector correlations; gamma; central bank liquidity; and a kind of “success breeds success” dynamic in short vol strats.
Of course low vol isn’t unique to equities. This is a cross-asset phenomenon and indeed, it’s created a veritable bonanza in credit as BofAML’s Barnaby Martin recently outlined.
Well, at this point we’ve either reached a point where this is such a worn out topic that nothing anyone can write is truly incremental or we’ve reached a point where, because we’re searching high and low for anything we haven’t already heard, everything is incremental. And I’m not sure which. There’s a fine line there.
So at the risk of offering nothing new, below find excerpts from Barclays’ latest on this hottest of hot topics.
A number of factors have driven the big drop in realized and implied equity volatility (“vol”) but the vol reset has been broad based across assets with 6m volatilities now 70-80% of 5-year average levels. Bond volatility has actually risen recently as equity volatility has fallen. Interestingly, periods of low relative equity volatility have historically been followed by strong 12-month returns. Overall we see the shifts in relative volatility as supportive of many of our investment views.
Better growth, lower macroeconomic volatility and increased vol selling drove equity vol down, though most drivers are reaching their limits. In our view, the first principal component for risk, and thus volatility, is the growth backdrop. Indeed, US equity vol has inversely tracked manufacturing ISM. Volatility in industrial production and inflation have fallen toward historic lows, impacting equity vol – though inflation vol has ticked up. FX, oil and rates implied vol has also fallen considerably since November 2016. Finally, with VIX futures positioning at a record net short, investor volatility selling has put downward pressure on equity vol.
Low equity vol has historically been followed by above-average returns. While volatility is likely to revert higher, we find that 12m forward US equity returns have averaged 10%+ when relative equity vol is well below average. The earnings yield on US equities is over 2x the yield on the US10y while relative equity/bond vol has converged to well below 2x. Over one year into an economic and earnings recovery the better relative sharpe ratio for equities points to continued solid returns.