Powell opens the door to a 50-basis-point rate hike, interest rates shoot up and equities crash. And yet, at the time of writing, the VIX index is below 20, raising the question of whether equities are not a bit complacent.
You can probably already hear a little from my tone what my answer is going to be. Still, there is a good reason why implied volatility looks relatively low.
Realised volatility
For one, realised volatility has come down hard. As the chart below shows, realised volatility based on the last fortnight is below 15. The last time this happened was before the 2022 bear market began. Typically, expected and realised volatility move within a fairly narrow range.
Earnings and macro windfalls
The decline in realised volatility can be explained by two developments. First, most macro figures were better than expected in recent weeks. This is reflected in a rise in the Citi Economic Surprise Indices. Pictured below are those indices for the Eurozone and the United States.
So far, the 2023 rally has neatly coincided with improving economic momentum. For many investors, this means the hard landing scenario can be binned. I myself am more on the ‹there is no reprieve from procrastination› scenario.
The second reason is earnings season. It is true that corporate profits fell in the fourth quarter of last year compared to the three months before, but there was no collapse. Moreover, sales continued to rise steadily. This suggests that high inflation is causing profit pressure, but not, as yet, a drop in turnover. With almost all the five hundred companies in the S&P 500 Index having published their figures, the stock market has again come through this quarter in one piece, with declining volatility as a result.
Nothing to worry about?
Certainly there is! Incessant setbacks and expectations of more interest rate hikes by the Federal Reserve led to another breakout in the MOVE index. Implied volatility in bond markets is rapidly increasing. Of course, sticky inflation and higher interest rates are also affecting equity markets. For a good example, I refer to my column from last week: Are equities too expensive?
It follows from the chart above that the divergence between the VIX and the MOVE Index is increasing again. Unless you judge that this is mainly because volatility in bond markets is overestimated, this lurks a risk for equities. Not least because they are thus too expensive relative to (short-term) interest rates. Besides, even relative to volatility in currency markets, equities look a tad “complacent”. I remain cautious about equities in a well-diversified multi-asset portfolio.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Monday on Investment Officer Luxembourg.