What has happened to Volatility?

I read recently that “this is perhaps the most dangerous time in the markets since September 2008 because of the unpredictability and illogical behaviour of politicians”. 

It is hard to disagree with that statement as we watch Theresa May struggle to cobble together a Brexit deal that will be acceptable to all parties and as we watch Trump risk alienating himself from his own supporters by appearing to align himself with Putin.  What will happen to the UK?  How will that affect the level of Sterling? Will Theresa May keep her job?  Will Trump make it to a second term, or even to the end of his first term?  No one can know for sure what the answers to these questions are or indeed what the long term effects will be.  That should be elevating uncertainty in financial markets.

But the S&P 500 index is just 2% below its all-time high.  The Nasdaq is at its high.  The FTSE 100 Index is just 3.5% off its high.  Even if we look at what is known as the market’s ‘fear gauge’ (the VIX) it is at just 12.1 compared to the long term range of 9 to 150. 

So what is VIX exactly?  For any mathematicians out there, it is standard deviation. In simple terms, it is volatility, which is a measure of variability of prices. VIX actually represents the volatility implied in S&P 500 index options.  When investors are uncertain, they are prepared to pay more for options to buy or sell S&P 500 companies.  That is the effect of volatility.

If you are a buyer of options then higher volatility makes your hedge (or speculation) more expensive. If you are a seller of options, higher volatility will increase your income.

Why is volatility so low given that we appear to be facing so many macro and political uncertainties in the world?  There are numerous possible explanations.  It is a fact that nominal interest rates have fallen and that has dragged down the level of potential returns from most asset classes.  That alone might give rise to lower volatility.  But the worry might be that extraordinary monetary policy since the Global Financial Crisis has distorted bond yields and with it levels of volatility and that during a period of rising rates and rising inflation, volatility will return.

There are many difficult questions here but our observation is that the low level of volatility gives a good opportunity to add some insurance to portfolios at a time when the fixed income asset class offers modest upside at best, even in the event of a crisis. 

Volatility rises when equity markets fall and so having a long exposure to the implied volatility in option prices can provide useful negative correlation to risk assets (such as equities) and help to diversify a balanced portfolio and soften the downside, should equity markets sell off.

In my next article I will describe how we combine a number of volatility driven instruments in the Waverton Protection Strategy and how we think that can help investors who may be concerned about downside risk.  

By Jeff Keen

17.07.18

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