We’ve been pretty keen on noting the market’s veritable obsession with low volatility.
Indeed, at least one analyst has dubbed it a “VIX-ation.”
It’s evolved (or maybe “devolved” is better) into a game of one-upmanship among analysts and on Tuesday evening, Goldman delivered their “magnum-volpus” in the form of a white paper called “The upside of boring: Risks & asset allocation in low vol regimes.”
It is one helluva long piece and Goldman gets points for putting their stamp on this most popular of hot market topics, but since there’s a lot going on this morning, we’ll hit the high points and then break it down further when we get around to it.
Essentially, Goldman says what you’re seeing isn’t as unusual as it seems and because it usually takes an “unknown unknown” to snap markets out of their slumber, predicting when this will end is quite difficult. They do note that central banks have played a role and if they exit the market, that could be bad news. Of course they also remind you that prolonged periods of suppressed vol lead to “excessive risk taking” as the carry-friendly environment causes people to move out the risk curve, a dynamic DB’s Aleksandar Kocic illustrated last week as follows:
Here’s Bloomberg’s summary of Goldman’s piece:
- Periods of low volatility are not unusual and have tended to last in past instances as the macro backdrop was very supportive, with improving growth, anchored rates and inflation, Goldman Sachs strategists including Christian Mueller-Glissmann write in a note.
- Since 1928, there were 15 low volatility periods that lasted 18 months on average
- Many volatility spikes in the past were hard to anticipate because they often occurred after unpredictable events
- Still, volatility regimes are closely linked to the business cycle; low jobless rates tend to anchor volatility for stocks and rates, while growing unemployment signals recession risk and a higher vol regime
- Central-bank uncertainty could push volatility higher going forward; with vol of vol higher, Goldman sees little sign of a structural shift downwards in equity volatility
- A period of prolonged low volatility may lead to excessive risk taking and can mask correlation risk in multi- asset portfolios
- It’s time to consider “all options”; Goldman likes cash extraction through equity calls and put spreads to hedge tail risk
And without further ado, here’s the executive summary from Goldman along with some of the visuals that illustrate the bullet points…
Since Q1 2016, volatility across assets, and in particular for equities, has declined and stayed remarkably low YTD. As a result, investors often ask how long the current ‘boring’ markets can continue, and what the risks and asset allocation implications are.
Long periods of low volatility are not as unusual as they may seem. Low volatility tends to linger — if volatility is very low, it often stays low in the subsequent 12 months. We identify 15 low vol periods for the S&P 500 since 1928 and, on average, they lasted 18 months.
The macro backdrop during those periods was very supportive, resembling a ‘Goldilocks’ scenario of improving growth with anchored rates and inflation, similar to now.
Timing the end of such a low volatility period is unsurprisingly difficult. Historically, many volatility spikes were hard to predict as they often occur after unpredictable events, so-called ‘unknown unknowns’.
However, volatility regimes are closely linked to the business cycle. Low unemployment rates tend to anchor equity and rates volatility, whereas rising unemployment signals recession risk and a higher vol regime.
The Great Moderation coupled with central bank buffering have likely helped reduce volatility structurally, in particular for bonds. But uncertainty on central bank policies could drive higher volatility going forward.
For equities we see little sign of a structural shift downwards in volatility, in part as vol of vol has increased.
Low vol periods are usually ‘risk on’ and carry-friendly, with both equity and credit valuations increasing.
However, a prolonged low vol period can also result in excessive risk taking. And it can mask correlation risk in multi-asset portfolios.
As implied volatility has reached decade lows across assets, we think it is time for investors to consider all options. We like cash extraction through calls in equities and put spreads to hedge tail risk.