A model that predicts realized volatility based on macro inputs was pretty accurate for 2019, Goldman says, in a note dated Friday.
Specifically, the bank’s model suggested baseline volatility for the S&P would be 13.4 this year. So far, SPX has realized 12.9.
“There were only three significant draw-downs during 2019, and they all were minor in comparison to Feb-2018 and 4Q2018”, the bank notes.
As you may be aware, Goldman’s outlook for the US economy is upbeat versus consensus for 2020. The bank sees just a 20% chance of a recession next year, versus consensus estimates at 33%. That raises the obvious question: What does their macro model say about volatility in the new year?
Well, based on Goldman’s house view for PCE growth, Unemployment, ISM manufacturing new orders, core CPI and core PPI, SPX baseline monthly volatility will be 14.7 on average for 2020, higher than what the model tipped for 2019.
The expected increase comes courtesy of projections for weaker industrial numbers, a shallower drop in the unemployment rate and a larger gap between core CPI and core PPI. As the bank explains, “these three factors boost our modeled volatility expectation by +0.6, +0.4 and +0.4, respectively for a combined increase of about 1.35 points vs the 13.4 estimated a year ago”.
You might notice from the visual that getting to the 14.7 figure assumes considerable improvement in the macro backdrop, something the bank readily acknowledges.
“Using the latest reported economic data, our model estimates baseline monthly SPX volatility should be running at 19.7”, Goldman says, on the way to noting that the majority of the expected five point decline from there to 14.7 is down to the assumption of “significant improvement on the industrial side of the economy”, even as some of those same industrial indicators are also behind the expectation of higher volatility in 2020 versus 2019.
So, what could get us to, say, 20 for 2020? Well, here’s what Goldman has to say about that:
While it is always possible (likely in fact) that global events or technical factors cause a temporary spike in volatility, we have shown that baseline volatility is highly correlated with the strength of underlying economic data. Our model suggests volatility would likely rise to 20 if ISM manufacturing new orders dropped to 45 or there was a consistent quarterly contraction of PCE of 1% (-4% annual growth). More moderate combinations of contractions in manufacturing and the consumer could also produce a 20 realized volatility (e.g. ISM new orders at 47 and PCE growth of 0%).
In other words, it is a virtual certainty that vol. will spike here and there in the new year based on “global events” (which in 2020 is just a euphemism for “Donald Trump’s foreign policy”) and “technical factors” (which is a truncated nod to modern market structure which can create vicious, self-feeding loops) but if history is any guide, baseline volatility should remain reasonably subdued unless the econ falls off a cliff.
On Friday, following the blockbuster November jobs report, it seems far-fetched to suggest that the US economy is anywhere near taking a sudden dive. But remember, it was just four days ago when another sub-50 ISM manufacturing print conspired with a Trump tweet aiming the tariff gun at Brazil and Argentina to deep-six sentiment.
Given the pernicious link between trade uncertainty and the macro data (which was on full display in August, when ISM first fell into contraction and consumer sentiment cratered to a Trump-era nadir following a serious tariff escalation), it’s worth adding a generic caveat that this can all turn on a dime.
Finally, if you’re wondering how that 14.7 estimate for 2020 stacks up to history, it’s below the mean and above the median.