From tug of war to volatility
Where does all this put our outlook on volatility? In mid-April, we wrote in our March monthly newsletter about the proverbial tug of war between two extreme forces: (1) potential negative outcomes with COVID-19 and the economic impact and (2) the unprecedented fiscal and monetary stimulus applied the world over. A tug of war typically starts with an equilibrium with two equal opposing forces, but when one side starts to prevail it typically ends in a rapid collapse of this equilibrium. In the markets the potential for severe movement either way did support elevated volatility levels, despite briefly in a rangebound equilibrium. Since then, the stimulus appears to have won for now as is visible in the markets’ stellar performance (the fastest and sharpest recovery from a bear market in history) as well as in the declined levels of market volatility. Markets could race on higher still, but even in bullish scenarios we do not foresee an imminent return to the extreme volatility suppression we have seen in recent years.
Yes, markets are cyclical and memories are short, but some of the technical reasons that encouraged leveraged volatility selling now suggest more cautious sizing. VaR-based risk measures that focus on recent history will likely limit many investors’ ability to take on large short volatility positions in the near-term. With the peak in equity volatility in March similar to the peaks in 2008, stress tests will likely get renewed focus too.
But will it be ‘party like it’s 1999’ as the retail fueled surge in some household names has been likened to the dot-com craze at the end of the last millennium? Markets can move higher and even sharp upward moves cannot be ruled out. However, downside risks seem more prevalent to us at current levels. It is the expectation of movement either side that ought to keep volatility levels relatively elevated in our view. Markets have started to price in a small premium for the US elections in a developing bump in the curve around November implied volatility, but we believe that a number of risks could also play out in the nearer future.
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1. Elle Koeze. “The $600 Unemployment Booster Shot, State by State”. The New York Times, April 23rd 2020
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