by For most of 2015, it was difficult to perturb U.S. financial markets. Despite protracted negotiations between Greece and its creditors that almost broke up the European Union and a Chinese stock market crash, equity market volatility remained remarkably subdued for most of the year. But the relative tranquility shattered on August 24, when disappointing manufacturing data out of China sparked a selloff in the Chinese stock market that spread to financial markets all over the world. Volatility jumped to a high of 53 during the trading day and has remained above 25, a key psychological threshold, until early September. Just like fashion, volatility has its seasons, and the recent panic began just before the three most volatile months of the year – September, October, and November. Add in the continuing crisis in China, the potential for the Federal Reserve to hike interest rates before the year’s end, and the beginning of third quarter earnings season, and Credit Suisse’s Private Banking & Wealth Management Division thinks this bout of turbulence could last for some time yet, if not much longer than the three months it usually takes for volatility to trough after an initial spike. “Markets were long overdue for an uptick in volatility,” says Barbara Reinhard,” Chief Investment Officer for the Americas.
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For most of 2015, it was difficult to perturb U.S. financial markets. Despite protracted negotiations between Greece and its creditors that almost broke up the European Union and a Chinese stock market crash, equity market volatility remained remarkably subdued for most of the year. But the relative tranquility shattered on August 24, when disappointing manufacturing data out of China sparked a selloff in the Chinese stock market that spread to financial markets all over the world. Volatility jumped to a high of 53 during the trading day and has remained above 25, a key psychological threshold, until early September.
Just like fashion, volatility has its seasons, and the recent panic began just before the three most volatile months of the year – September, October, and November. Add in the continuing crisis in China, the potential for the Federal Reserve to hike interest rates before the year’s end, and the beginning of third quarter earnings season, and Credit Suisse’s Private Banking & Wealth Management Division thinks this bout of turbulence could last for some time yet, if not much longer than the three months it usually takes for volatility to trough after an initial spike. “Markets were long overdue for an uptick in volatility,” says Barbara Reinhard,” Chief Investment Officer for the Americas. “Now that it has arrived, investors need to ensure that they are positioned for success.”
When considering the consequences of higher volatility, it’s important to understand what the term actually means and how it’s tracked. Generally speaking, volatility is the degree to which the price of a given index or individual stock varies over a period of time. The best-known volatility measure, the Chicago Board Options Exchange Volatility Index, or VIX, tracks the price of S&P 500 options with between 23 and 37 days until maturity to gauge how much people are willing to pay for insurance against a big market move in the next 30 days. For that reason, the VIX is often called the “fear index.” Similar measures, including the MOVE index, measure volatility in fixed-income markets by tracking demand for options that expire in 30 days on U.S. Treasury notes of varying durations.
The VIX has experienced 17 big spikes – defined as an upward move of at least one standard deviation from a recent trough – since the S&P 500 hit bottom in March 2009. There have been at least three such spikes in every year since 2009, but just one to date in 2015.
Meanwhile, the MOVE index has experienced three spikes of at least one standard deviation in 2015. One came in early January, as investors interpreted a continued fall in oil prices as a sign of weak global demand and sold off stocks in favor of bonds. A smaller spike occurred in mid-May, in the midst of a huge selloff in European bonds that spilled into the market for Treasuries. The third occurred in August, alongside the equities rout, as investors rattled by plunging stock markets fled to the relative safety of government bonds.
This year’s volatility spikes each present a different kind of foreshadowing about what could lie ahead for financial markets.
Take the bond market’s May spike first. Most economists attributed the selloff in European bonds to investors unwinding a set of crowded trades based on the idea that yields would fall after the European Central Bank began quantitative easing. But that doesn’t explain the intense selling pressure U.S. bonds experienced at the same time. Between April 24 and May 6, yields on 10-year Treasury notes spiked from 1.93 percent to 2.25 percent, a 32 basis-point move. And the culprit seems to be liquidity. Credit Suisse and others have been warning for months that as many financial institutions have pulled back from their role as market makers due to more stringent capital requirements, the resulting reduction in liquidity posed a threat to the market’s stability. Credit Suisse thinks it’s likely to amplify any initial volatility that occurs when the Federal Reserve tightens policy.
Meanwhile, the volatility spikes in January and August show that U.S. markets are not immune to outside pressures. China, for instance, remains a potential catalyst for higher volatility. In 2014, the single spike in bond market volatility coincided with a broader risk-on move across asset classes due at least in part to disappointing Chinese economic data and rapidly falling oil prices. This year, the Chinese government has tried everything from devaluing the currency to banning short-selling to try to arrest a slide in financial markets that could have serious implications for growth in the world’s second-largest economy. And when it didn’t appear to be working, markets around the world began to quake. The purchasing managers index survey showed that Chinese manufacturing activity fell to 49.7 in August, the survey’s lowest reading in three years as well as an indicator that the sector is actually contracting.
When it comes to volatility, however, investors cannot forget about the most important potential catalyst of all: the Federal Reserve. The last two times markets experienced swings of the same magnitude as those in August were in the summer of 2013, after then-Federal Reserve Chairman Ben Bernanke first mentioned in May the possibility of the central bank tapering asset purchases, and in October 2014, when the U.S. central bank wound down its third quantitative easing program for good. In other words, significant changes either in the Fed’s actual policy or in the market’s expectations about future policy have been responsible for the largest volatility spikes of the last few years. With the Federal Reserve on course to raise rates before the end of the year, investors should prepare for market drama in the coming months.
Of course, any number of geopolitical events could also cause turbulence in the markets, according to El Helou. Signs of renewed tension from Russia, a further devolution of the situation in the Middle East, or complications stemming from the recent nuclear deal with Iran could throw markets into disarray. And those are only the potential headaches that are already on investors’ radar – it’s the crises no one sees coming that could really send volatility soaring.
While the idea of volatility makes many investors nervous, the best investors position themselves to profit from big market swings. Credit Suisse suggests that investors use available cash to buy on significant dips during any coming volatility spikes and consider options overlay strategies and certain structured products that perform best when markets are gyrating.