Volatility is back, and here's why
February 9, 2018

Chris Iggo, Chief Investment Officer Fixed Income at AXA Investment Managers, gives his droll and informative summary of the investment week.

Volatility is back and those that bet on it never coming back have had a tough week. Why is it back? It's back because the macro fundamentals are evolving in a way that many of us have expected but some have denied. Growth is strong, inflation is not dead and interest rates are rising. This is spooking the bond market and the bond market spooks everyone else. The veracity of the moves in equities are explained by the existence of structured trades, algorithms and leverage, but the reason that valuations are being challenged is because the discount rate is rising and is not going back down any time soon. Bond investors might start to be tempted to buy US treasuries as we approach a 3 percent yield but the cat is out of the bag – we are in a higher yield environment than we have been for the last three years and that is a bit of a problem – not a terminal problem – but a bit of a problem for equities.               

Old fashioned –  Call me old-fashioned but bitcoin1 is not a currency and volatility is not an asset class. The former's exponential increase in price last year was a classic example of the "greater fool theory" while the emergence of widespread investor losses in products linked to equity volatility over the last week should remind us all that there is "no free lunch" in financial markets. No matter how smart the structure, the further an investment proposition is away from real cashflows and intrinsic value, the more likely it is to go horribly wrong, often out of the blue. Investors, and I use the term loosely, have lost money this week because they had bought products that were inversely linked to the Chicago Board Options Exchange Volatility Index (Vix). When equity prices started to decline sharply following the release of the January employment report in the United States, measures of volatility jumped. The Vix itself was trading at a price of 13 on the 1st of February. On the 5th it rose quickly and the following day hit a high of 50. If you were "short" the index, you were – as they might say in the pits in Chicago – "toast". 

Uncertainty – Volatility measures and associated instruments in financial markets are attempts to capture and measure uncertainty. Uncertainty is a principle component of investing alongside value, yield and liquidity. When you invest you can never be sure what the outcome will be. This is obvious and provides the rational underpinning of investment concepts like diversification and hedging and is behind the historical development of the derivatives industry. Uncertainty also determines, to some extent, the decision whether to accept as appropriate the level of expected return on an investment strategy – in all asset classes. And there is uncertainty everywhere. In fixed rate government bonds there is uncertainty over whether inflation will eat away at the yield return. In corporate bonds there is uncertainty over getting paid back as a creditor and instead becoming the owner of a distressed asset. In equities there is the uncertainty over the course of earnings of the companies whose stock one owns. Paying for some insurance to narrow the scope of uncertainty over future investment outcomes is a very rational thing to do. This approach, portfolio hedging, is really about paying a premium to neutralize some of the uncertainty in the investment outcome. That premium is modelled as the mathematical "best guess" as to how much it should cost to protect against a certain level of uncertain outcomes.

Insurance –  That is all very different from betting on the uncertainty about the uncertainty. This is essentially what volatility traders do. They make markets and trade on a view about whether levels of volatility – as represented in options markets for a whole range of asset classes – are likely to go up or down. They don't know, obviously. So their bets are uncertainty times uncertainty! Yet, for the most part this works and creates an efficient market in trading volatility so that end investors can get an efficient price for volatility based hedges. Rational behavior would suggest that when the price of volatility is low (i.e. that the market collectively thinks that future prices of assets will be relatively stable) then investors should take the opportunity to purchase "cheap" insurance. Conversely, when the price of volatility is high, end investors are put off buying insurance because they don't believe that the prices of the underlying assets are going to move enough to justify paying the insurance premium. Call me old fashioned again, but this sounds a bit like "buy low, sell high".

Madness – Which makes recent events seem remarkable. While asset managers and investment bank trading desks have been struggling to generate returns in recent years because investment and trading opportunities have been curtailed by the lack of volatility, some participants in the market have been following "short volatility" strategies even with actual and implied volatility being at historical lows. In essence, "selling low". One can only believe that the rational for this strategy was based on the belief that volatility would remain low or move even lower on the back of macroeconomic and market stability delivered by ongoing central bank intervention in markets and regulatory restrictions on risk taking. The "return" on this type of strategy was to receive the option premium or the price of the insurance contract. Being exposed to inverse movements in the Vix, writing option strategies in foreign exchange and equity markets and selling protection in the credit default swap (CDS) market are all manifestations of the same trade. If the belief has been in some quarters that inflation would never go up, therefore interest rates and bond yields will stay close to current levels - which are not a problem for credit and equity markets - then the temptation was to benefit from someone else's willingness to pay a premium to insure themselves against that view being incorrect. Taking in the option premium by being short volatility has been a technique used by some to boost the yield on portfolios or as an outright trading bet, typically in the form of some structured products (and throw in some leverage to boot). The jump in the Vix at the beginning of the week has generated significant losses in some of those short volatility trades, according to press and other media reports.

Denial – These crises always elevate obscure activities to the broader narrative of events in financial markets. Inverse Vix strategies were hardly known a week ago just like few people outside of the credit derivatives market knew about the extent of sub-prime lending and special purpose vehicle financing in 2008. But that's a good thing. Exposing stupidity always benefits the greater good in the long-run. In the most recent case I am also of the view that the increase in volatility has been a long time coming. There is a certain amount of denial amongst investors that the big declines in equity indices was purely a technical derivative of the unwinding of these short volatility strategies with moves triggering bigger moves. While no doubt positioning and algorithmic trading amplified the move in equities, the underlying cause was fundamental. Bond yields are moving higher because we are in a stage of the business cycle where growth is strong around the world, spare capacity is limited, inflation is starting to pick up and central banks are shifting the emphasis of monetary policy. With equities having risen to very high valuations, it makes sense that there should be some valuation adjustment. If risk-free rates are re-valuing then so should risky assets (even if it is just to account for a higher discount rate).

Risk premiums –  There is nothing new in the fundamental story but market timing is one of the most obvious uncertainties in our business. It was suggested in some research I read in the last couple of weeks that US pension funds would be reducing their allocation to equities and rebalancing portfolios on the basis that equity markets had done so well last year and delivered very strong returns in January alone. A short-term explanation could have been the surprising strength of wage growth in the January employment report. The year-over-year rate of average earnings growth jumped to 2.9 percent in January, the highest growth rate since 2009. With US companies granting one-off bonuses or wage increases on the back of the tax deal, it looks as though the tightness of the labour market is now showing up in some wage inflation. This is good for growth but it also reinforces the determination that the Federal Reserve (Fed) has to normalise the level of interest rates. That normalization means, according to the Fed's projections, a policy rate of 3 percent by the end of 2019. Higher rates mean the end of super-easy monetary policy and that brings into question the relative valuation of equities. Now I am not saying that equity markets have peaked – I have no idea as the future is uncertain – but maybe there needs to be more of an equity risk premium. If corporate earnings keep growing strongly, then stocks can keep rising. It is worth noting that the rise in bond yields and the decline in the dividend yields on the S&P index now means nominal bond yields are some 1 percent higher than the estimated equity yield. Bonds have been getting cheaper since September while equity indices kept getting more expensive.

Seeing the cycle – The higher rates / risk-off scenario is one that I have been anticipating for some time. I don't think this is genuinely it yet as the fundamentals are still very supportive for risky assets. In the fixed income world, credit spreads have hardly budged during this period of increase equity volatility. Since the beginning of the year US high-yield spreads to treasuries are actually lower and are only 20 basis points (bps) higher than the low reached last month. It's the same story for investment grade credit indices, European high-yield and emerging market sovereigns and corporate bonds. Overall yields are higher, but most of this has come from the underlying move in rates and credit excess returns have, on the whole, stayed positive. In the credit markets, the equivalent of the Vix is the range of credit default swap indices. They have moved higher since the beginning of the year, from extremely low levels. However, the move has not been that extreme with the US investment grade CDS index up around 10 points (to 55) and the European cross-over index up 45 points (to 265) since the lows established in January. The price action here indicates not much more than bond investors taking a look over to the equity markets, and then adding a bit of very cheap insurance to their credit portfolios. No panic as yet, although the crossover index did spike up towards the end of the week. Whether greater levels of panic will emerge or not remains to be seen but ultimately, in my opinion, rising US rates and the acceleration of the normalization of monetary policy in the rest of the world, will cause more of a problem for risky assets. For some time I have believed that the timeline will be characterized by rates bottoming (happened), rates reacting to stronger growth and inflationary trends (the US and UK central banks have started to increase rates), investors worrying that higher rates will hit growth (sometime later), risky assets underperforming and duration trades being the winners in fixed income. The latter part of that chain of events will play out over the next couple of years.

Sit tight – So at the moment the preferred bond strategy is to sit tight with a short duration bias and less exposure to the higher beta parts of the credit universe, waiting for wider spreads and even higher yields. Our most flexible multi fixed income asset strategy is flat for the year when most single fixed income indices / strategies have posted a negative total return. Valuation is coming back but bonds are hardly cheap yet. The index yield in US dollars on the US investment grade corporate bond index is still just 3.6 percent. In high-yield it is just above 6 percent, matching the level seen in Q1 last year. Unfortunately for European investors, when hedged back into euros or sterling the yield is not that attractive (3.6 percent in euro, around 4.5 percent in sterling and the foreign exchange hedge is likely to cost more in the months ahead as the US raises rates again). European bond yields remain paltry unless you compare the 0.85 percent yield on the investment grade index with a -0.4 percent cash rate. There is more potential for yields to rise and there is potential for some of this to come from wider credit risk premiums. So sit tight and avoid losses is my view of what to do.





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Chris Iggo, Chief Investment Officer Fixed Income at AXA Investment Managers, gives his droll and informative summary of the investment week.

Volatility is back and those that bet on it never coming back have had a tough week. Why is it back? It's back because the macro fundamentals are evolving in a way that many of us have expected but some have denied. Growth is strong, inflation is not dead and interest rates are rising. This is spooking the bond market and the bond market spooks everyone else. The veracity of the moves in equities are explained by the existence of structured trades, algorithms and leverage, but the reason that valuations are being challenged is because the discount rate is rising and is not going back down any time soon. Bond investors might start to be tempted to buy US treasuries as we approach a 3 percent yield but the cat is out of the bag – we are in a higher yield environment than we have been for the last three years and that is a bit of a problem – not a terminal problem – but a bit of a problem for equities.               

Old fashioned –  Call me old-fashioned but bitcoin1 is not a currency and volatility is not an asset class. The former's exponential increase in price last year was a classic example of the "greater fool theory" while the emergence of widespread investor losses in products linked to equity volatility over the last week should remind us all that there is "no free lunch" in financial markets. No matter how smart the structure, the further an investment proposition is away from real cashflows and intrinsic value, the more likely it is to go horribly wrong, often out of the blue. Investors, and I use the term loosely, have lost money this week because they had bought products that were inversely linked to the Chicago Board Options Exchange Volatility Index (Vix). When equity prices started to decline sharply following the release of the January employment report in the United States, measures of volatility jumped. The Vix itself was trading at a price of 13 on the 1st of February. On the 5th it rose quickly and the following day hit a high of 50. If you were "short" the index, you were – as they might say in the pits in Chicago – "toast". 

Uncertainty – Volatility measures and associated instruments in financial markets are attempts to capture and measure uncertainty. Uncertainty is a principle component of investing alongside value, yield and liquidity. When you invest you can never be sure what the outcome will be. This is obvious and provides the rational underpinning of investment concepts like diversification and hedging and is behind the historical development of the derivatives industry. Uncertainty also determines, to some extent, the decision whether to accept as appropriate the level of expected return on an investment strategy – in all asset classes. And there is uncertainty everywhere. In fixed rate government bonds there is uncertainty over whether inflation will eat away at the yield return. In corporate bonds there is uncertainty over getting paid back as a creditor and instead becoming the owner of a distressed asset. In equities there is the uncertainty over the course of earnings of the companies whose stock one owns. Paying for some insurance to narrow the scope of uncertainty over future investment outcomes is a very rational thing to do. This approach, portfolio hedging, is really about paying a premium to neutralize some of the uncertainty in the investment outcome. That premium is modelled as the mathematical "best guess" as to how much it should cost to protect against a certain level of uncertain outcomes.

Insurance –  That is all very different from betting on the uncertainty about the uncertainty. This is essentially what volatility traders do. They make markets and trade on a view about whether levels of volatility – as represented in options markets for a whole range of asset classes – are likely to go up or down. They don't know, obviously. So their bets are uncertainty times uncertainty! Yet, for the most part this works and creates an efficient market in trading volatility so that end investors can get an efficient price for volatility based hedges. Rational behavior would suggest that when the price of volatility is low (i.e. that the market collectively thinks that future prices of assets will be relatively stable) then investors should take the opportunity to purchase "cheap" insurance. Conversely, when the price of volatility is high, end investors are put off buying insurance because they don't believe that the prices of the underlying assets are going to move enough to justify paying the insurance premium. Call me old fashioned again, but this sounds a bit like "buy low, sell high".

Madness – Which makes recent events seem remarkable. While asset managers and investment bank trading desks have been struggling to generate returns in recent years because investment and trading opportunities have been curtailed by the lack of volatility, some participants in the market have been following "short volatility" strategies even with actual and implied volatility being at historical lows. In essence, "selling low". One can only believe that the rational for this strategy was based on the belief that volatility would remain low or move even lower on the back of macroeconomic and market stability delivered by ongoing central bank intervention in markets and regulatory restrictions on risk taking. The "return" on this type of strategy was to receive the option premium or the price of the insurance contract. Being exposed to inverse movements in the Vix, writing option strategies in foreign exchange and equity markets and selling protection in the credit default swap (CDS) market are all manifestations of the same trade. If the belief has been in some quarters that inflation would never go up, therefore interest rates and bond yields will stay close to current levels - which are not a problem for credit and equity markets - then the temptation was to benefit from someone else's willingness to pay a premium to insure themselves against that view being incorrect. Taking in the option premium by being short volatility has been a technique used by some to boost the yield on portfolios or as an outright trading bet, typically in the form of some structured products (and throw in some leverage to boot). The jump in the Vix at the beginning of the week has generated significant losses in some of those short volatility trades, according to press and other media reports.

Denial – These crises always elevate obscure activities to the broader narrative of events in financial markets. Inverse Vix strategies were hardly known a week ago just like few people outside of the credit derivatives market knew about the extent of sub-prime lending and special purpose vehicle financing in 2008. But that's a good thing. Exposing stupidity always benefits the greater good in the long-run. In the most recent case I am also of the view that the increase in volatility has been a long time coming. There is a certain amount of denial amongst investors that the big declines in equity indices was purely a technical derivative of the unwinding of these short volatility strategies with moves triggering bigger moves. While no doubt positioning and algorithmic trading amplified the move in equities, the underlying cause was fundamental. Bond yields are moving higher because we are in a stage of the business cycle where growth is strong around the world, spare capacity is limited, inflation is starting to pick up and central banks are shifting the emphasis of monetary policy. With equities having risen to very high valuations, it makes sense that there should be some valuation adjustment. If risk-free rates are re-valuing then so should risky assets (even if it is just to account for a higher discount rate).

Risk premiums –  There is nothing new in the fundamental story but market timing is one of the most obvious uncertainties in our business. It was suggested in some research I read in the last couple of weeks that US pension funds would be reducing their allocation to equities and rebalancing portfolios on the basis that equity markets had done so well last year and delivered very strong returns in January alone. A short-term explanation could have been the surprising strength of wage growth in the January employment report. The year-over-year rate of average earnings growth jumped to 2.9 percent in January, the highest growth rate since 2009. With US companies granting one-off bonuses or wage increases on the back of the tax deal, it looks as though the tightness of the labour market is now showing up in some wage inflation. This is good for growth but it also reinforces the determination that the Federal Reserve (Fed) has to normalise the level of interest rates. That normalization means, according to the Fed's projections, a policy rate of 3 percent by the end of 2019. Higher rates mean the end of super-easy monetary policy and that brings into question the relative valuation of equities. Now I am not saying that equity markets have peaked – I have no idea as the future is uncertain – but maybe there needs to be more of an equity risk premium. If corporate earnings keep growing strongly, then stocks can keep rising. It is worth noting that the rise in bond yields and the decline in the dividend yields on the S&P index now means nominal bond yields are some 1 percent higher than the estimated equity yield. Bonds have been getting cheaper since September while equity indices kept getting more expensive.

Seeing the cycle – The higher rates / risk-off scenario is one that I have been anticipating for some time. I don't think this is genuinely it yet as the fundamentals are still very supportive for risky assets. In the fixed income world, credit spreads have hardly budged during this period of increase equity volatility. Since the beginning of the year US high-yield spreads to treasuries are actually lower and are only 20 basis points (bps) higher than the low reached last month. It's the same story for investment grade credit indices, European high-yield and emerging market sovereigns and corporate bonds. Overall yields are higher, but most of this has come from the underlying move in rates and credit excess returns have, on the whole, stayed positive. In the credit markets, the equivalent of the Vix is the range of credit default swap indices. They have moved higher since the beginning of the year, from extremely low levels. However, the move has not been that extreme with the US investment grade CDS index up around 10 points (to 55) and the European cross-over index up 45 points (to 265) since the lows established in January. The price action here indicates not much more than bond investors taking a look over to the equity markets, and then adding a bit of very cheap insurance to their credit portfolios. No panic as yet, although the crossover index did spike up towards the end of the week. Whether greater levels of panic will emerge or not remains to be seen but ultimately, in my opinion, rising US rates and the acceleration of the normalization of monetary policy in the rest of the world, will cause more of a problem for risky assets. For some time I have believed that the timeline will be characterized by rates bottoming (happened), rates reacting to stronger growth and inflationary trends (the US and UK central banks have started to increase rates), investors worrying that higher rates will hit growth (sometime later), risky assets underperforming and duration trades being the winners in fixed income. The latter part of that chain of events will play out over the next couple of years.

Sit tight – So at the moment the preferred bond strategy is to sit tight with a short duration bias and less exposure to the higher beta parts of the credit universe, waiting for wider spreads and even higher yields. Our most flexible multi fixed income asset strategy is flat for the year when most single fixed income indices / strategies have posted a negative total return. Valuation is coming back but bonds are hardly cheap yet. The index yield in US dollars on the US investment grade corporate bond index is still just 3.6 percent. In high-yield it is just above 6 percent, matching the level seen in Q1 last year. Unfortunately for European investors, when hedged back into euros or sterling the yield is not that attractive (3.6 percent in euro, around 4.5 percent in sterling and the foreign exchange hedge is likely to cost more in the months ahead as the US raises rates again). European bond yields remain paltry unless you compare the 0.85 percent yield on the investment grade index with a -0.4 percent cash rate. There is more potential for yields to rise and there is potential for some of this to come from wider credit risk premiums. So sit tight and avoid losses is my view of what to do.



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