Risk of higher volatility for stocks is rising
The spike in volatility in equity markets late last week might well be a foretaste of things to come. Markets are heading into the uncertain outcomes of the midterm elections in the US amid rising worries over the risk of intensified conflict in Iran and investor questions about the rollout of AI infrastructure.
There have been signs that a pick-up in volatility had been coming. Equity markets have been remarkably resilient this year. Almost unbelievably so.
Wars in Ukraine and the Middle East have triggered higher volatility in sovereign bond and commodity markets.
But indices of investor expectations of equity volatility implied by options trading — the Vix index in the US and the Vstoxx index in Europe — have been relatively calm with an average level of 16.3 and 17.7 per cent, respectively, over the past three months, in line with longterm averages. The so-called fear gauge indices appeared “fearless” until midway through last week.
The most common explanation is the strong earnings growth driven by significant capital expenditure on the AI value chain, from hyperscale data centres and semiconductors to memory chips and energy infrastructure.
Fiscal deficits with large tax cuts in the US and defence spending in Europe have also contributed to rising corporate profits.
The recent resilience is despite expectations that the wars in Ukraine and Iran increasingly appear to have little prospect of a resolution anytime soon.
The risk of an escalation where both the straits of Hormuz and of Bab al-Mandeb can be shut in the context of depleted global energy reserves should have led to higher equity volatility risk premia. It did not.
Having lost the argument that inflation would be “transitory” in 2022, central banks are not taking any chances and have embarked on a new tightening cycle with more rises expected by the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan over the next six to 12 months.
The subsequent rise in global bond yields will eventually force fiscal consolidation as debt servicing costs rise, increasing fears around sustainability.
Higher bond yield volatility should have increased equity volatility — as the stream of future earnings that underpins stock valuations is discounted by the combination of bond yields and equity risk premia.
Even corporate credit pricing has come under pressure in both investment grade and high-yield sectors.
So why did equity index volatility remain subdued? Is equity sentiment somehow immune to rising interest rates, geopolitical risks and higher credit spreads?
Well, the underlying picture for individual stocks has been a different story
om the broad index. When the gains of a given sector or stocks are offset by the losses of another, the index moves very little.
For example, oil and gas companies versus transportation companies, AI hardware versus AI software, companies that benefit from higher interest rates such as financials versus those that suffer, like utilities.
Looking at equity index performance can be as misleading as looking at the tip of an iceberg, especially for volatility. And we are now seeing high sector rotation by investors and the dispersion of stock returns. Take, for example, the Stoxx Europe 50 index.
If you look at all the possible pairs of single stocks in the index, the proportion with a negative correlation for three-month periods over the past five years has risen to an unprecedented high of 30 per cent. It is 40 per cent for Wall Street’s S&P 500 index.
Apart from current investment themes such as the energy supply and AI demand shock, such “social distancing” dynamics might also be a symptom of a new market structure, reflecting the more aggressive deployment of systematic long-short investing strategies.
Equity volatility risk is being transformed and stored in negatively correlated pairs. A broad change in the correlation of these stock pairs could gradually, or suddenly, force more components of the index to move in the same direction.
The result could be sharply higher index volatility if, for instance, the odds of a recession increase materially.
Markets have an equivalent to the law of conservation of energy in physics. Risk is never destroyed, only transformed. We can see how risk is transforming and the manifestation of it in equity markets is coming sooner than many think.
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