Calling lows during risk-off events with any precision is obviously difficult, that said, conditions are conducive for a bounce. Equity market measures of risk are exceptionally elevated. The VIX, VVIX and term structure of VIX futures, are each more than 2 standard deviations above their post-crisis median. Additionally, skew has increased, which has not been typical post-crisis, except in extreme circumstances like the early February 2018 volatility explosion. Correlation was exceptionally low prior to this risk-off event, it has risen sharply. Credit spreads were exceptionally tight, they are now closer to their post-crisis median. The VIX exceeded 30 in both of the 2018 risk-off episodes, however note that in our chart below that volatility spikes tend to be transitory. On balance, equity market measures of risk are quite elevated, implying investors are fearful.
We used the impact of the 2019 tariff tweet business confidence shocks and related stock market declines, to ‘model’ downside risk as 6-7%. We are now down 8% from the peak, given that the relationship between business confidence and the equity market, we should be close to a low. We continue to believe that the supply chain disruption has not yet reached the point where it will exceed the 2011 Japanese tsunami shutdown of the global auto industry. We do not expect the negative impact on business confidence to exceed the trade war shock, largely because confidence was at a two-decade high prior to the trade war, while prior to the coronavirus virus, confidence was at its lowest level since 2016, with an inventory restocking cycle just beginning. None of the news this week, or discussions we had at the NABE conference in DC, dissuaded us from our views on the supply chain or business confidence effects, we expected the virus to spread. We suggest adding some risk, software looks interesting, it has been hit hard and the secular trends are strong.
Figure 1: The VIX, volatility of volatility and term structure of volatility are each more than 2 standard deviations above their post-crisis median. Typically, skew would be cheapening as the market fell and volatility increased. For example, during the QT crash in December 2018 this occured, though during ‘volmageddon’ in February 2018 skew also richened when volatility exploded. During the February and December 2018 episodes, the VIX peaked at 37.32 & 36.07, the VVIX at 177.34 & 111.88 and term structure -13.8 & -4.8. The current readings are below those levels.
Figure 2: Notice that volatility spikes are brief while low volatility tends to persist.
Figure 3: Rates are at new lows, yet implied volatility is lower than the August spike. This is likely attributable to Fed asset purchases and the volatility dampening effect.
Barry C. Knapp
Managing Partner
Ironsides Macroeconomics LLC
908-821-7584
https://ironsidesmacro.substack.com
https://www.linkedin.com/in/barry-c-knapp/
@barryknapp
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