There’s no better way to introduce Deutsche Bank’s latest on the low vol regime than to quote a piece we penned a couple of weeks ago.
And even if there was a better way to introduce it, there’s nothing like a little self-aggrandizing to boost one’s ego and quoting oneself is a great way to self-aggrandize.
So with that in mind, here’s what we said previously about the market’s obsession with explaining suppressed vol.:
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.
Right. Well on Friday, we got the latest form Deutsche on the outlook for vol and it’s a pretty comprehensive piece with lots of fun, colorful charts. Here’s the gist of it from the opening paragraph:
We have reached low vol levels not seen since the 2014 or 2005-2007 regimes. Our analysis suggests that the lower vol regime persists, and we lower our ESTOXX 50 3M IV range to 13-18% (previously 15-20%) over the summer, but we expect to rise this back to 15-20% when we re-enter Q4’17. Vol spikes are still expected in 2017, but lower in magnitude than in 2015/16. There is now a convergence of risks in 2018, but we are not saying 2018 will be a high vol year, more likely that there will be a series of ‘market recalibrations’ as macro forces evolve (e.g. higher than expected inflation).
Drilling down, the first thing we get is a snapshot of the situation in Europe:
Followed by a recap of where we stand on Deutsche’s “Golden Rules.”
Only one of our Risk metrics is higher risk than our 2017 Outlook.
Rule 1: Monetary & Fiscal Activity risk = MEDIUM (up from Low in 2017 Outlook): Some liquidity measures point towards stability, but others, such as Global excess liquidity, are rolling over. Our US Economists expect more rate hikes than the market expects in 2018, which runs the risk of pushing up real rates, and tightening financial conditions. Overall, a faster pace of Fed rate hikes; a tipping over of some liquidity measures; and reduced chances of significant fiscal measures in the US point to rising risks of higher volatility into 2018. However there is often a long lag time before some of these measures are felt, hence in the near-term we are not yet concerned, so only move the risk from Low to Medium (rather than high).
Rule 2: Economic growth risk = LOW (Low in 2017 Outlook): DB Economists expect above consensus growth in the US and Europe for 2017-18, and this will likely act as a vol dampener. Further, there are few signs of excessive growth expectations (either GDP or European EPS). Our US Asset Allocation team reinforce this lack of exuberance, showing recent strong US soft data simply ‘catching up’ to hard data. Separately, our analysis shows that recent sharp falls in surprise indices only pose significant vol spike risk if they fall to highly negative levels. Outside of Europe, a China growth shock is often seen as a catalyst, but we see less risk now for China as an epicentre for a higher vol regime, reinforced by the upcoming National Congress in October.
Rule 3: Geopolitical risk = LOW (down from Medium in 2017 Outlook): Tail risk from Geo-political risk has shifted down a gear since the French elections. We continue to believe that to cause major volatility event, these catalysts need a backdrop of economic growth concerns either in parallel with, or caused by, the catalyst. With a backdrop of stable growth expectations, we believe any vol spikes around these events will be dampened. The key potential event is an early Italian election, but DB Economists still expect a low chance of a populist majority, limiting the risk.
Rule 4: Positioning risk = LOW (Low in 2017 Outlook): We think that equity exposure has not yet reached extremes: Beta-to-market of some US and Europe fund types remains low, and our European Equity Strategists also show recent inflows to European equities are unlikely to have reversed years of outflows. Additionally, our US Equity Derivatives Research team believe most vol feedback loops are lower risk than some participants fear. Positioning can also be assessed through valuations: in absolute terms valuations have risen steadily since the GFC, but our Global Asset Allocation Team highlight Europe trading at a discount to the US, providing support to European equities. European equities also do not appear stretched vs corporate bonds.
Rule 5: Long-term leverage: Risk = MEDIUM (Medium in 2017 Outlook): Longer-term trends show relatively stable credit levels through 2017, which continues to remove another possible volatility catalyst. More concerning is rising non-financial corporate leverage, although household leverage remains constrained. Interest coverage ratios for US IG non-financial remain close to lows since 2006, however this is of less short-term concern with US and European ratings on an uptrend since mid 2016. Overall, unless interest rates spike aggressively (e.g. much faster than expected Fed rate hike pace), then current levels of leverage appear sustainable. We remain alert to, but not yet concerned about, the short-term risks from current levels of leverage.
Next is a discussion of the macro drivers of equity vol, summarized in the following table:
Deutsche moves on to note that depending on how you look at things, what we’re seeing now isn’t necessarily an anomaly. “Figure 8 shows the current vol regime is not atypical, with many examples of low vol regimes lasting for many more months/tears,” the bank notes, referencing the following chart:
So what could cause things to shift? Or, put differently, what could usher in a period of higher vol?
Well, there are six factors according to Deutsche, four of which are “less likely,” and two “more likely.” Here they are:
LESS likely catalysts to trigger a new higher vol regime are:
- Less European bank contagion risk, given stronger and some less correlated risks drivers in European banks.
- China’s recent growth stability has allowed some industries (e.g. Miners) to adapt to lower growth (falling lead indicators have already seen heavy declines in miners spot and valuations, showing some of this has already been priced in). Measures to tackle non-Bank financial leverage in China are worth monitoring, but are not yet significantly affecting credit supply to the broader economy.
- European political risk (e.g. early Italy election) is most likely to raise vol only in parallel with major growth fears. Our Economists base case is for a coalition without populist eurosceptic parties. ECB protective measures such as OMT provide additional stability mechanisms.
- Sharp EUR rallies run the risk of weaker European growth, and creating deflationary pressure. In reality, our FX team see a greater likelihood of EUR weakness into 2018 (parity to USD in 2018).
MORE likely catalysts to trigger a new higher vol regime are:
- US inflation surprise to upside: (a) our Economists show the risk in 2018-2019 of tighter labor markets, and weaker productivity growth, provoking faster than expected rate rises (Golden Rule 1). Our Multi Asset Allocation team sees even nearer term inflation risk. They show core PCE inflation is negatively correlated with USD. The drag from a strong USD on core PCE inflation has been at 20 year extremes, and a slower USD rally in future will see this reverse. The inflation impact may be only 30-40 bp in scale, but investors and/or the Fed may initially fear a faster than anticipated rate hike cycle.
- Policy failure and return to deflationary regime: i.e. drivers behind the reflation debate (fiscal spending, deregulation, tax cuts) become nonviable. E.g. if there was sufficient loss of political support in the US for many of Trump’s policies such that the chance of successful execution falls towards zero, then central banks may need to return to the forefront of the deflation battle. Central Bank support for the economy was starting to lose credibility amongst some investors last year.
Basically, the greatest risk here is a Trump-related policy failure in the US that causes central banks to reverse course and step back in to stave off another deflationary spiral.
So what should you do?
That part is intuitive. Sell vol for now and buy longer-dated protection for a tail hedge.
“It’s so easy.”