Low Vol Regime In Perspective

Volatility is the most disturbing factor in financial markets and it’s something people should always keep an eye on. Measured by popular metrics like VIX or VSTOXX, it’s assimilated to the « fear indicator » of investors.

Looking at the long past of the US equity market (S&P 500 in chart below), you can see that volatility goes in regimes that can change widely but rely mainly on macro environment (expansion/recession) and it’s impact on the psychology of investor (P/E or valuation).

Volatility in equity market in perspective

Source: Goldman Sachs

Volatility across asset classes: now vs history

Volatility in the equity space is the most monitored indicator, but volatility of other asset classes is also worth considering – per Goldman Sachs report date June 20, 2017, here are some historical references:

Source: Goldman Sachs

« Since Q1 2016, realized volatility across assets has declined sharply and has stayed remarkably low YTD, closer to its lows since 1970. On the surface this is at odds with investor perception of risk currently, with high valuations across assets, the US economy moving more late cycle and heightened policy uncertainty and geopolitical risks (to name some of the concerns).

We are nearing (but are still well above) levels last seen during the low vol period of 2014, which preceded a sharp increase in volatility owing to the EM/oil crisis of 2015.

Also, on two occasions in the 1970s volatility was much lower across assets than it is right now.

Looking at average volatility for different asset classes reveals a broad shift lower and generally volatility across assets has moved together since the Global Financial Crisis (GFC). However, equity volatility stand out as particularly low relative to their history. »

Source: Goldman Sachs

Drivers of volatility

Low unemployment, higher growth and moderate inflation numbers – what some brokers label ‘Goldilock environment’ – largely contribute to this low vol.

Actually, per GS report, « low volatility periods often occur as the economy moves more late cycle« .

Recessions « often drove higher volatility first for rates, then for equities », i.e. volatility is countercyclical – inflation tends to pick up, recession risk increases which drives higher volatility.

On the flip side, « great moderation » and macroprudential policies explain low volatility regimes. Great moderation is associated with low GDP growth, low inflation and less volatility unemployment.

Another key driver of low vol is central banks policies. « The last 20 years have market one of the longest periods of consistently negative equity/bond return correlations in history. (…) The prevailing monetary policy regime with more aggressive inflation targeting has likely contributed to ever lower real rates as inflation risk premia have declined. (…) asset purchases by central banks further anchored bond yields. »

Building Asset Allocation in Low Vol Regime

Low vol is usually « Risk-On » and « Carry » friendly. This means that FOMO is at full speed. The only issue, say GS’s strategists, is that « low vol periods often end in tears ».

The key risk for investors is when they have the false impression that low correlation among asset classes is helping them diversify, while it should sharpen their risk aversion – especially the case when valuations are tight –  and have them consider macro factors/drivers of higher risk/volatility in their portfolio.

If correlation suddenly rises between equities and bonds, because they all the sudden become more sensitive to rising macro uncertainty, investors have limited options to find cover. Either they go into alternative strategies (private equity), i.e. broader diversification, or move into cash.

The other risk investors should think about is the popularity of « short volatility » positioning. According to GS, « the XIV (short shorter-dated VIX future ETF) has nearly tripled since the beginning of last year. As a result, the net and outright short position in VIX futures is at all-time highs. »

Other ways to protect from rising volatility is to set up derivatives strategies, such as « equity straddles (long at the money calls and puts). A 1-month S&P 500 straddle currently costs 1.68%, which is close to the lowest level (1.64%) since 1999; this is also the breakeven, i.e. how much the S&P 500 needs to move in the next month for a positive P&L. »

« By being long straddles, investors can get a return in strongly trending markets with relatively low volatility. »

Equity drawdown risk can be managed through longer-dated call options for multi-asset portfolios, say GS. In Europe and Japan, « option premia are low and long-dated vol is anchored due to structured product flows. (…) Along a similar vein, convertible bonds are an asset class that tends to become more attractive in low vol periods due to their embedded longer-dated equity options and comparably low duration risk. »