15 Mar 2016
Why volatility is here to stay – SocGen
Research Team at Societe Generale, notes that the volatility has increased across all asset classes.
Key Quotes
• “Despite central banks maintaining their extraordinary easing stance, the global economy slowed in Q1. The global composite PMI fell significantly to 50.6 in March (vs 52.7 in December), as weakness spread from the manufacturing sector to services, raising fears of a recession.
• Against this backdrop, financial conditions have tightened, with a broad-based rise in market volatility and wider credit spreads (not only in commodity-related sectors). This is clearly a risk to monitor, as the deterioration in financial conditions could impact the real economy.
• Volatility has been exacerbated by two major sources of uncertainty: China and the oil price. The uncertainty surrounding these two factors is likely to persist throughout 2016.
Expensive valuations to trigger further volatility in 2016
• These factors should not overshadow the persistence of expensive valuations across major asset classes.
• Despite the corrections in equity markets in summer 2015 and Q1 16, there is still a mismatch between still-expensive valuations and sluggish global growth. For example, between 2012 and 2014, the S&P 500 gained 75%, while EPS grew only 20%. Such divergence between inflated equity prices and disappointing fundamentals will continue to support a volatile environment for equities in 2016.
• After a strong rally, sovereign bonds could also suffer more volatility going forward, as term premia have been compressed into negative territory again, owing in large part to unconventional central bank policies. A change in market sentiment (e.g. due to inflation bottoming out in the US) could trigger a sharp rebound in global bond yields.
Implications for volatility strategies
• Despite a sharp decline in equities in Q1 16, the rise in VIX has been less significant than during summer 2015. According to SG Derivatives analysts, this is most likely due to positioning. In July 2015, the net positions of hedge funds on VIX futures were strongly short, and the decline in equity led to a squeeze of speculative shorts forced to buy back their positions. In contrast, net speculative positioning stayed positive for more than two months after summer and turned positive again in Q1. This is in itself a sign that the mood has changed and that the market expects equity volatility to trade higher going forward.
• As a result, VIX volatility may remain somewhat limited due to more balanced positioning, challenging hedging strategies. See Global Equity Volatility Outlook.
• Short volatility strategies could also become more painful, as we expect a more volatile environment that might require tactical management.”
Key Quotes
• “Despite central banks maintaining their extraordinary easing stance, the global economy slowed in Q1. The global composite PMI fell significantly to 50.6 in March (vs 52.7 in December), as weakness spread from the manufacturing sector to services, raising fears of a recession.
• Against this backdrop, financial conditions have tightened, with a broad-based rise in market volatility and wider credit spreads (not only in commodity-related sectors). This is clearly a risk to monitor, as the deterioration in financial conditions could impact the real economy.
• Volatility has been exacerbated by two major sources of uncertainty: China and the oil price. The uncertainty surrounding these two factors is likely to persist throughout 2016.
Expensive valuations to trigger further volatility in 2016
• These factors should not overshadow the persistence of expensive valuations across major asset classes.
• Despite the corrections in equity markets in summer 2015 and Q1 16, there is still a mismatch between still-expensive valuations and sluggish global growth. For example, between 2012 and 2014, the S&P 500 gained 75%, while EPS grew only 20%. Such divergence between inflated equity prices and disappointing fundamentals will continue to support a volatile environment for equities in 2016.
• After a strong rally, sovereign bonds could also suffer more volatility going forward, as term premia have been compressed into negative territory again, owing in large part to unconventional central bank policies. A change in market sentiment (e.g. due to inflation bottoming out in the US) could trigger a sharp rebound in global bond yields.
Implications for volatility strategies
• Despite a sharp decline in equities in Q1 16, the rise in VIX has been less significant than during summer 2015. According to SG Derivatives analysts, this is most likely due to positioning. In July 2015, the net positions of hedge funds on VIX futures were strongly short, and the decline in equity led to a squeeze of speculative shorts forced to buy back their positions. In contrast, net speculative positioning stayed positive for more than two months after summer and turned positive again in Q1. This is in itself a sign that the mood has changed and that the market expects equity volatility to trade higher going forward.
• As a result, VIX volatility may remain somewhat limited due to more balanced positioning, challenging hedging strategies. See Global Equity Volatility Outlook.
• Short volatility strategies could also become more painful, as we expect a more volatile environment that might require tactical management.”