Right Tail Only, Please

By now, most market participants with more than a passing interest in the day-to-day goings-on are likely aware that equity volatility has mostly normalized following a prolonged period of “sticky” higher forward vol which owed its persistence to a stubborn supply-demand imbalance (more precisely: demand over supply). That eased a bit over the past several weeks.

As with anything else market-related, there’s some debate about what comes next. Earlier this month, for example, Goldman’s Rocky Fishman suggested the falling VIX was “an opportunity to add short-dated hedges.”

“We expect a return to 2021’s prevailing high volatility risk premium before long,” Fishman said.

Read more: Is VIX Decline An Opportunity To Add Hedges?

In their latest volatility outlook, dated Wednesday, SocGen’s Vincent Cassot and Jitesh Kumar compare the current environment to the “‘Trumpflation’ episode in 2016-17” which coincided with the low-/short- vol bubble presided over by Janet Yellen.

They elaborated, citing five key factors, the first of which is simply that reflationary macro regimes tend to be consistent with suppressed vol.

“Over the past 30 years, CPI levels of 2-3% have historically been consistent with the lowest average levels of volatility,” they wrote.

The question for those skeptical of the Fed’s benign take on inflation, is “Yes, but for how long?” That is: How long before we get into a more dangerous “bucket”? To let the doomsayers tell it, what we’re currently seeing in, for example, lumber prices, will be happening in more than just wood soon enough. And it won’t be “transitory.” That’s not my view, for whatever that’s worth. If I were building a porch (or buying a house), I might be a bit more irritated by the situation.

SocGen went on to cite fiscal and monetary largesse, noting that on some measures, financial conditions “are the easiest they’ve ever been.”

Over and over, I’ve emphasized that the tweaked language in the Fed’s mandate affords the Committee scope to remain as accommodative as they like in virtual perpetuity. In addition to insisting on seeing actual, realized inflation overshoot, the Fed has explicitly tied tightening to the achievement of a more inclusive labor market. American capitalism, in its current manifestation, isn’t likely to produce anyone’s idea of an egalitarian workforce anytime soon. Theoretically, the Fed could always cite “more work to be done” on that front as an excuse to keep accommodation in place.

As SocGen put it Wednesday, the combination of average inflation targeting and the tweaked employment mandate “implies that one of the main drivers of equity volatility (central bank real policy rates) will continue to point to lower volatility over the next few quarters.”

Moving along, the bank noted that low stock- and sector- correlations will work to tamp down index-level vol. This is a familiar dynamic in a market characterized by what Cassot called “intense” sector rotations. In making the comparison with 2016-2017, he noted that back then, “heavy volatility selling flows along with fiscal policy easing expectations helped push the level of annual volatility in the S&P to the lowest level since 1965.” Clearly, fiscal easing is in the pipeline again (albeit from the demand side this time) and low correlations are once again playing a role in suppressing index vol.

Crucially (and I do realize this is a tired argument, but there’s a good reason why so many people keep emphasizing it), there’s a veritable ocean of cash sitting idly on the sidelines.

I often show you the simple ICI chart, but the figure (below, from SocGen) gives you some better context. It speaks for itself, but as Cassot wrote Wednesday, “using money market assets as a proxy for cash, one can argue that investors cannot deploy capital fast enough to draw down this cash pile.”

Finally — and depending on how this is framed, it’s a point that agitates the creative destruction crowd — SocGen noted that stress in credit isn’t likely to materialize in a way that threatens equities.

“While our credit strategy team previously expected investor caution and higher defaults in credit in 2021, the strength of corporate working capital has argued in favor of a revision in the team’s default forecasts,” Cassot said, adding that spreads are likely to approach record lows in 2021.

Recall that high yield just set an April record for issuance. It’s a bonanza (figure below).

The fading prospects of credit events effectively removes the left-tail for stocks.

And what does that leave when it comes to vol catalysts? Well, right-tail, naturally.

“Without stress in credit, the only source of volatility for equities would be the right tail,” SocGen said. “And that would be a good thing for the broader market overall.”