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The Return of Volatility


UPDATED (7-May-2020): I wanted to revisit this blog post with an update, partly because it's really interesting and worth highlighting, and partly because one of my followers on Twitter remembered the old article and mentioned it to me the other day!

Basically, in the original article (back at the start of 2018), I remarked how it looked like volatility was headed higher -- the charts made it look fairly clear. But also as noted at the time: "3 key themes coalesce: a maturing cycle globally, a turning of the global monetary policy tides, and increasing valuations across asset classes and markets"

Remember when we were talking about a maturing business cycle? Well it did mature, and then rolled over thanks to tighter monetary policy and the trade war, but the recession turned out to be limited to manufacturing and exports... and just as we were coming out of that thanks to policy stimulus, of course the virus hit and here we are now!

But onto the charts. The first one shows the rolling 12-month count of daily percent changes exceeding +/- 1% -- basically an alternative view of volatility. At the time of the original article below, the indicator was just starting to turn up from a 50-year low, and is now resolutely on its way up. One thing I find interesting about this one is how the volatility of this volatility indicator has gone up.

While I am bullish risk assets over the medium-term, I would say we can probably get used to the idea of higher volatility in the foreseeable future.

As a sentiment indicator, global average implied volatility has acted more or less as it usually does during a market correction/crash, and the spike and climax in volatility coincided with the market bottom (of course, decisive policy intervention also helped act as a circuit breaker).

As to what happens next with the path of volatility, we should expect a degree of normalization, but I think we find a new higher floor in volatility over the next 12-18 months. Here's why: I can give you my list of reasons why I'm bullish/optimistic (and I think the rationale is compelling), but I can equally imagine a series of scenarios and likely/certain risk events on the horizon.

Furthermore, I have this sense that we live in an age where social media has become a dominant information source (which is a blessing and curse - given how emotions and misinformation can infect the flow) and paired with democratization of markets (zero trading costs, easy to trade via an app in small size, access to information) we might start to see more manic markets.

Another thing is, I look across screeds of surveys, market indicators, positioning data, and of course am privy to a hefty flow of anecdotal evidence, and my summation of that is that investors are fairly lightly positioned for the most part. Pessimism is high: that creates seeds for "virtuous volatility" - where markets can rip higher in a more erratic fashion... in fact, once everyone gets back to business, and this pandemic is over, there is a good chance that we find a global economy overstimulated, and a relief euphoria could take hold... possibly creating a dot-com style euphoria bubble in equities. But now I'm just off and wildly speculating. Interesting thoughts to think though...

yours,

Callum Thomas

Head of Research

Topdown Charts

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ORIGINAL POST (6 Feb 2018): Across a number of markets and asset classes, the past few weeks have served as a wake-up call, a reminder that volatility can return at pace. While it's normal for various measures of volatility and risk aversion to spike during a selloff or correction, my view is that this is just the start of a new regime of higher volatility. The charts below outline how this looks to be in process, and give some insight into how volatility has evolved across time.

The global macro backdrop certainly lends itself to a transition to higher volatility, and we've already had a taste of this with a falling US dollar, rising commodity prices, and spiking bond yields. The economic and policy backdrop underpins this, yet there is still cause for optimism in that the economic outlook remains solid, and earnings are on an improving path. So while rising volatility is often associated with risk, it can also be a time of rising opportunity.

The key takeaways on the outlook for stockmarket volatility are:

-An alternative view on realized price volatility is turning up from a 50-year low.

-Global equity implied volatility is turning up, which makes sense given the backdrop of a maturing cycle, turning tides in monetary policy, and increasing valuations.

-With the global economic outlook still solid, it could end up being a 1990's-style shift in volatility.

-Shorter term, the VVIX appears to be flagging a higher VIX.

1. Alternative Volatility View: This alternative view of volatility - the rolling annual count of daily price moves exceeding +/- 1% - shows just how profoundly low volatility has been in the new bull market. With the price action of the past week this volatility indicator has started to turn (from the lowest levels since 1966). It could end up being just a flash in the pan, but my view is it is the start of the process of turning up. A key open question is whether this is a return of volatility like in the late 1990's or something more like the mid-2000's. I am leaning toward the former - which would basically be a more erratic bull market.

2. Global Equity Volatility: Already, on the global front, average implied equity volatility across the major global equity markets had been in a clear bottoming process. In the 2018 Outlook article, I noted how this is likely a bottom in implied volatility on a global level as 3 key themes coalesce: a maturing cycle globally, a turning of the global monetary policy tides, and increasing valuations across asset classes and markets. This is the riskier part of the cycle as investor sentiment starts to change.

3. The VIX of VIX: A possible trend toward generally higher levels of volatility appears to have been flagged by the CBOE VVIX (implied volatility of the VIX, or "the VIX of VIX"). And the apparent, albeit relatively loose, link with the VIX seems to suggest the VIX heads or stays higher from here. Thinking about the macro backdrop, greater volatility across some of the key macro variables is going to be key in determining the risk and opportunity backdrop this year. An apparent bear market in the US dollar, rising bond yields, rising commodity prices, and greater uncertainty on the path of monetary policy could mean that while the overall growth and inflation (and hence earnings) outlook remains positive, the price movements across asst classes will become increasingly volatile as we enter the later innings of the cycle.

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