And so the debate continues about if and/or when volatility in equities will spillover to other asset classes.
While cross-asset vol. jumped in early February, equities stood out and there’s been no shortage of discussion about the extent to which the lack of contagion to FX vol. seems to suggest that markets aren’t overly concerned that the aggressive trade rhetoric will ultimately mushroom into an all-out international tariff tit-for-tat that imperils the future of global trade and commerce.
There are of course a variety of factors that help explain why the uptick in vol. this year has been an equities-centric phenomenon and why it’s been most pronounced in the U.S. I talked about this at length last week. I’ll take the liberty of quoting myself:
Clearly, the blowup of the short VIX ETPs in early February played a role in making the U.S. experience unique and the forced de-risking by systematic strategies (think: CTAs and risk parity) that unfolded in early February made things worse. While the wipeout of the ETPs essentially cleared the deck in terms of those products’ ability to turbocharge a volatility spike, it’s not clear that some of the strategies that were caught up in the subsequent deleveraging have rebuilt their positions.
Additionally, it looks like passive investors are contributing to elevated volatility stateside, an unsurprising development considering how manic the flows into and out of some of the more popular index funds have been this year. That same propensity for investors to pile into and out of the big ETFs seems to have contributed to the recent spike in stock correlations.
On the psychological front, there’s no question that the incessant headlines from the Trump administration are making U.S. investors nervous. Even ostensibly positive news seems to come not of its own accord, but rather in response to some previous headline that the administration thinks might have been misinterpreted or otherwise unnerved folks. And then there’s the psychological overhang from the Mueller probe. Not having any idea what the next shoe to drop will be in the special counsel investigation is a constant thorn in the side of traders, as there’s no way to hedge it.
As Goldman writes in a new note out Monday, “a combination of technical factors, fears on Tech regulation as well as US trade war escalation drove more volatility in US equities compared to other markets and assets.”
The bank illustrates this using a collection of charts that document the frequency of outsized moves in equities versus other asset classes. Specifically, they look at the number of sessions when returns were at least 3 standard deviations from the mean.
“Equities displayed the largest number of these moves with the S&P 500 having several 3 standard deviation return days YTD – both other equity markets and assets had much fewer,” Goldman writes.
And while they go on to point out that the “recent number of 3 standard deviation returns for the S&P has been below long term historical peaks,” the preponderance of these moves nevertheless “collocates in the upper end of the distribution”:
Yay! We got to use the word “collocates” today. Achievement unlocked.
Ultimately, Goldman echoes something BofAML said earlier this month; namely that even if volatility does ultimately settle, we’re unlikely to see a return to the lake placid environment that characterized 2017. Here’s how BofAML put it a couple of weeks back:
Importantly, even if US equities do end up recovering to set new highs in 2018, perhaps on the back of a strong earnings season, simply breaking the trend of rapid recoveries (and the Pavlov BTD mentality), should prevent a return to the 2017 bubble lows in volatility.
And it’s not just the breaking of the BTFD, Pavlovian response that will keep vol. from resetting to 2017 levels. Remember that part and parcel of why equity volatility was able to remain suppressed last year was the presumed viability of the “Goldilocks” narrative (synchronous global growth and still-subdued inflation). There are now very real questions about whether that narrative still holds.
“We expect volatility to settle lower compared with the elevated levels YTD, although a shift back to a low vol regime like in 2017 appears less likely,” Goldman concludes.
On the “bright” side, the higher the volatility, the better the outlook for the bank’s equities business, right?
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Once bitten, twice shy.