Dissecting the Wall of Worry

  • Equity-market volatility hit an all-time low in Q3
  • Low volatility and strong equity markets were likely the result of improved economic fundamentals during the period
  • On the other hand, policy uncertainty, stretched valuations, excessive risk taking and a slight increase in medium-term recession risk warrant more targeted risk taking in portfolios


What does volatility tell us about market risk? If there was ever a quarter to ask that question, it was in Q3 when the CBOE Volatility Index (VIX) hit an all-time low of 8.84. During the same period, the US experienced three major hurricanes, political turmoil, serious doubts about tax reform, and threats of nuclear war with North Korea, while globally asset classes remained highly valued from an historical perspective. As Richard Thaler, the recent winner of the Nobel Prize in Economics, remarked, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” So what gives?

The VIX is often referred to as the “fear index” because it is so strongly negatively correlated with equity market movements; when the Index is low, it suggests market participants are complacent about risk and, when it is high, investors are typically risk averse. However, a low VIX isn’t always a harbinger of market stress. At times it has been low and falling for years during periods of relative market calm. This has typically happened in the context of solid economic growth and low inflation – the so-called Goldilocks economy (not too hot, not too cold). This is what market bulls are hoping is emerging in today’s economy.

This may be the most plausible explanation for what drove markets higher during the quarter and kept volatility at bay. In Q3, US GDP growth accelerated, global growth improved (particularly in China and Europe), inflation remained subdued and the US labor market continued to tighten, while corporate earnings remained strong. It was enough good news to keep the Federal Reserve on track to raise rates again before the end of the year, even in the face of three particularly destructive hurricanes. (With the exception of early labor market readings, much of the economic damage from those events has yet to show up in broader economic data.)

However, while economic fundamentals have been improving, policy uncertainty has not. The list of events contributing to economic policy uncertainty is exhausting and includes a lack of progress on tax reform and infrastructure spending, failed healthcare reform, talk of trade wars, and so on. The relationship between policy uncertainty and market volatility is typically strong and, in a normal world, each of these events individually would have the potential to seriously disrupt markets. However, today the gap between policy uncertainty and the VIX has rarely been higher. We don’t necessarily know what explains the current divergence, but it is clear to us that volatility markets are not reflecting the current state of this uncertainty:

(Policy uncertainty as measured by the Global Economic Policy Uncertainty (GEPU) Index, a GDP-weighted average of economic policy uncertainty indices for 18 countries.)


Ironically, low volatility itself can contribute to excessive risk taking, ultimately sowing the seeds of future volatility events. Take, for example, the level of money investors are willing to borrow to buy equities as shown by the level of outstanding margin debt. Investors do this when they feel comfortable taking risk, a sentiment that tends to prevail after markets have been steadily rising for an extended period. The dark side of this behavior is that when markets fall and that margin debt has to be repaid, it can amplify market moves as selling to meet margin calls begets further selling. Currently, margin debt is at a new record - higher than during the dotcom boom and roughly 10% higher than its previous peak in 2015:

(Margin debt as measured by the sum of free credit cash accounts and credit balances in margin accounts minus margin debt.)


Finally, even though current economic fundamentals have been strong, the market’s estimation of the economy’s future path is a bit less optimistic. Equity markets are notoriously poor predictors of recessions, whereas fixed income markets have been an excellent at this historically. While there have been a few false positives along the way, the yield curve (specifically the difference between the rate on 10-year Treasury bonds and three-month T-bills) has predicted seven of the last eight US recessions since 1960. And, since late last year, this measure has crept up while equity markets volatility has remained oddly subdued. Current levels imply a mere 10% likelihood of recession 12 months out - up from 2.5% a year ago - but the lack of any meaningful downside volatility alongside this change suggest equity markets are giving greater weight to current fundamentals and optimism about policy reforms than they are to the path of interest rates and their implication for future growth prospects:

(Recession probability as measured by the spread between the rate on 10-year Treasuries and three-month Treasury bills.)


There seems to be an inherent contradiction in having great optimism about future policy outcomes during a period of historically extreme policy uncertainty. Certainty should drive optimism, not the other way around! Furthermore, today’s high policy uncertainty is materially different than previous episodes, which include single events like the September 11 attacks, the credit crisis in 2008, the Eurozone crisis in 2011 or the Brexit vote more recently. Today’s uncertainty emanates from many sources – the direction of Fed policy, national security issues, major regulatory and fiscal changes, a fractured political process, and basic doubts about the future of free trade. And, as we know, a number of these uncertainties have potentially extreme consequences.

So, what does volatility tell us about market risk? Apparently very little. At the very least it is a backward-looking measure of uncertainty and at best it is a paradox; risk may be greatest when the market perceives there to be little. As risk expert Richard Bookstaber notes, “Greater uncertainty leads to more predictable behavior.  Within the limited world of finance, this predictability is a decided negative.” We know the market is complacent about risk, but we can’t necessarily know why. However, the complacency itself – a behavior that has led to stretched valuations, hope-filled risk taking and excessive leverage - is reason to remain on guard.


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