Is a low VIX the calm before the storm for investors?

Jun 7th, 2017 | By | Category: ETF and Index News

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Markets have recently been awash with chatter about the low level of the VIX Index, a widely-followed measure of investor uncertainty around the short-term outlook for US equities. Despite a small spike in the week that concerns over the Trump/Russia links came to a head, the VIX has been subdued for the best part of a year and recently dipped to its lowest level since 1993.

The calm before the storm - what does a low VIX really mean for investors

Are investors too complacent? Do the historically low levels of the VIX Index imply a greater risk of a “black swan” event?

All this despite a backdrop of seemingly heightened political uncertainty surrounding Trump, Brexit and elections in Europe, as well as the looming end to ultra-accommodative monetary policy and increased concerns regarding equity valuations. So why is the VIX  so low and should investors be worried? Is this the calm before the storm?

Depressed levels of the VIX are often taken as a sign of investor complacency regarding market risks. However, investors’ perceptions of future volatility are very closely related to historical volatility and this has also been at low levels recently, according to Matthew Joyce and Daniel Morris of BNP Paribas. “The question of why the VIX is so low – or why investors expect future volatility to be so modest – should also consider why realised volatility has been so low. The point being that investors may not only be complacent, but that observed market volatility has simply been limited.”

Joyce and Morris argue that observed volatility is likely low at the moment thanks to the Fed signalling their commitment to very gradual policy tightening, as well as the synchronised global economic upswing helping to reduce investor anxiety over high equity valuations. Commodity price volatility is also low thanks to a subdued oil price, and quantitative easing has reduced bond yields and bond price volatility for the last several years.

George Bonne of MSCI also points out that stock correlations are at very low levels in 2017 which has contributed to low levels of overall realised volatility. “We find that three measures of volatility – implied, realised and forecast – have been consistent with each other and reflect market conditions.”

So if the low levels of the VIX index can be explained by market factors despite the apparent risks, what should investors read into it? Does the current low level of the VIX imply investors are about to be caught out by a jump in volatility and a correction in the S&P 500?

Joyce and Morris think not. “Over a long-term time horizon there is little evidence that low volatility implies poor future returns for the S&P 500. The correlation between the VIX and subsequent three-month or one-year returns is actually positive, albeit just slightly so.”

And despite being mean-reverting, the VIX can remain at subdued levels for extended periods of time, most notably in 1993-1995 and 2005-2006.

Timothy Graf, head of macro strategy EMEA for State Street Global Markets, thinks that despite the low VIX index, investor sentiment is neither complacent nor overly optimistic and doesn’t see a correction in the short-term. “Despite the strong performance of risky assets, worry still seems to dominate market thinking. However, we see some evidence that benign market conditions can hold into the second half of this year. Global demand conditions still look fairly robust.”

Richard Turnill of Blackrock agrees: “Our “risk ratio” gauge of rick appetite is at levels consistent with moderate risk taking, but nowhere near the “irrational exuberance” seen in the late 1900s or mid-2000s.”

However, Bonne cautions against the risk of “black swans”, a term coined by author Nassim Taleb to describe low-probability, high-impact events. “Look beyond the widely followed “fear index” (VIX) and you’ll find that markets remain concerned about a black swan. How do we know this? Because investors are buying downside protection for their portfolios in the form of deep out-of-the-money put options. Both recently and since the financial crisis, the options skew has been high for the level of the VIX, implying investors are increasingly concerned about the likelihood of an extreme negative market event”

So while on the surface all seems calm, many investors are jittery about left-tail risk – the small probability of a large downward move in equities. It is very easy to buy into the idea that supposed investor complacency might precipitate another crash. However, as Graf points out, in 2004-2007 most investors shared a rosy view of the global economy whereas this time, everybody is talking about the potential risks, so complacency is difficult to argue despite the low VIX readings.

Ultimately, it’s possible that it is difficult to glean much information about the near future from the VIX index, a view shared by Michael Baxter of Share Centre. “Recall, that while the VIX index fell below 10 in 2006, less than two years later the global economy suffered its worst financial crisis in 80 years. Just because the VIX is low, it does not mean that all is well, but then neither does it automatically mean crisis is around the corner.”

While the “Trump trade” appears to have gone out of favour in recent months, many market commentators are forecasting business as usual in the short-term at least. “2017 earnings momentum is strong. We see global reflation and an improving earnings outlook supporting cyclicals and exporters,” said Turnhill.

“Price-based measures of market fragility continue to recede, suggesting a lower probability of sharp drawdowns in risky asset valuations. We still favour overweights in equities against fixed income and think US reflation prospects are nowhere near as poor as market pricing for the dollar and US rates might suggest,” added Graf.

Calculated by the Chicago Board Options Exchange (CBOE), the VIX reflects implied volatility on 30-day options on the S&P 500 Index.

Investors can gain exposure to the VIX index using the Lyxor S&P VIX Futures Enhanced Roll (Lux) UCITS ETF (LON: LVO) which has a total expense ratio of 0.60% and assets under management of €41 million. Investors in this ETF profit when the VIX rises higher, reflecting increasing uncertainty in the market.

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