Don’t Panic: Volatility Tail Wags the Market Dog

Equities Down and Out. Having reached an all-time high on 26 January the USDow Jones Index has subsequently taken just over a week to book its largest points fall on record and the largest percentage decline since 2011. Meanwhile, having recorded an all time-low as recently as January 3, the VIX Index – a measure of the implied volatility of the US S&P 500 – exploded  to reach the highest level since China’s currency devaluation in August 2015. From its US origins, the selloff has quickly become global. No wonder some are feeling queasy. 

The ‘short volatility’ trade could well be to blame. Cosseted by hyperactive central banks, many market participants had readily concluded that insuring against higher volatility (‘long vol’) was a waste of premium whilst selling volatility (‘short vol’) was a useful addition to market returns. Over time, strategies that directly or indirectly targeted volatility and a host of financial products that could enable the ‘short vol’ trade flourished. 2017 was particularly bloody for the ‘long vol’ holdouts. (Had you rolled over front month VIX Index futures you would have lost 73% of your investment). This left the market vulnerable to a pickup in volatility going into 2018.

Anatomy of a market meltdown. US bond volatility, as measured by the MOVE Index began to move meaningfully higher in the second half of January from close to all-time lows. The market finally digested the impact of tax cuts and a chronically weak dollar on inflation expectations that had been steadily firming through Q4 2017. This fallout was turbo-charged by comments from the Trump administration at Davos which seemed to sanction a weaker US Dollar and an aggressive trade policy. As noted below, the final straw was higher than expected US wage inflation for January last Friday.  Short bond volatility positions had to be closed, pushing bond volatility and bond yields higher still. As often happens, equities reacted to this with a delay, leading to Monday’s debacle.

But the growth story underpinning equities remains intact. At the macro level, we have already seen upgrades to economic growth forecasts in the US, Europe and Japan for 2018. At the stock level, the corresponding consensus earnings per share (EPS) forecasts for global equities has moved up c. 5%, supplementing already decent growth.

This is not a ‘Risk Off’ moment. It is notable that the recent equity selloff saw emerging markets outperform their developed market peers, despite a higher risk profile and a consensus overweight position in stock portfolios. It is unlikely this would have occurred had the recent market declines been prompted by a ‘risk off’ episode.

The US wage inflation scare is not all it seems. The final catalyst for the market selloff appears to have been the higher than expected January wage inflation print for the US last Friday. At 2.9% year-on-year this exceeded the forecast of 2.6% and clearly stressed already reeling bond markets. However, it is not widely appreciated that this number was elevated by 18 US states and 20 cities raising minimum wage levels in the month and that a more normalised figure would have been closer to 2.4%. More generally it should be noted that wage inflation is not a zero-sum game for companies. Much of the revenue is effectively re-cycled as revenue growth as employees are also consumers.

Volatility (sometimes) Equals Opportunity. It may sound like cant, but the most recent selloff will probably prove to be an oft-cited ‘healthy correction’, though I appreciate that it may not feel like that right now. It appears as though some of the investment vehicles that channelled destabilising short volatility bets will be forced to close. Many other accounts that were blindly following market momentum may hesitate to re-engage. It is probable that many accounts that have aggressively traded on margin (borrowings) will have been forced out of the market altogether. Inasmuch as the selloff has been largely indiscriminate some value has been revealed for opportunistic purchase.

More Alpha from Stock Selection? From an asset management perspective a generally higher level of market volatility – as might be expected in an environment where central banks are tentatively removing stimulus – could well be a function of a wider dispersion (range) of returns at the stock level. If this eventuates then the  scope for an actively managed portfolio to add alpha through stock selection should increase.

Asset Allocation Cannot be on Autopilot. The most recent market turn has also clearly illustrated the value of maintaining a suitably diversified portfolio incorporating a coherent and risk appropriate asset allocation process. If markets do indeed prove to be choppier going forward, then the active management and review of asset exposure is likely to be of increasing importance to ensure targeted risk-adjusted returns.