SPDR ETFs: Will debt ceiling debate end low volatility?

Aug 24th, 2017 | By | Category: ETF and Index News

By Michael Arone, chief investment strategist at State Street Global Advisors, the asset management firm behind the SPDR range of ETFs.

SPDR ETFs: Will debt ceiling debate end low volatility?

SPDR ETFs: Will debt ceiling debate end low volatility?

This summer, investors have been saying “hakuna matata” to the turmoil emanating from Washington and using a problem-free philosophy to send stocks to fresh highs and market volatility to multi-year lows. But investors should be prepared: September may bring a sudden dose of volatility to mellow markets.

Throughout the summer, Senators have once again been kicking the can down the road, delaying an agreement on raising the debt ceiling. This means that they are heading dangerously close to a September 29 deadline—the day the Treasury Department estimates it will run out of money to pay its debts and interest. A US government default would be too much for even a hakuna matata market to ignore. It would likely result in a sharp reduction in risk appetite, potentially sparking a bond rally and an equity sell-off, as well as further flattening the yield curve.

With reality setting in that Republicans have failed to pass any significant legislation since taking control of Congress in January—and the fact that they need to win over Democrats to pass debt ceiling legislation—subtle signs of unease are starting to bubble up in the market.

Can markets remain laissez-faire much longer?

Equity markets have kept their laissez-faire demeanour throughout the hot summer months. The chart below, which captures the ratio of the S&P 500 Index’s price-to-earnings to the CBOE Volatility Index (the VIX), shows just how frothy valuations are relative to volatility.

Over the last decade, US equities have exhibited an average one-to-one relationship between P/E and the VIX. But record-setting stock-market closings combined with nearly record-low volatility means that ratio is 83% above its ten-year average. Ultimately, this is a signal that investors may be too complacent.

Source: SSGA.

Investor hesitation creeping into the bond market

While equities appear to be summering in the waters off St. Tropez, bond traders may start to wonder if they’re facing a sunset on Jaws’ infamous Amity Island. The chart below shows that investors’ hesitations about whether lawmakers will be able to reach agreement on the debt ceiling are weighing on Treasury markets. October T-Bills, which would come due around the time of the potential default, are attracting selling action, which is widening their yields relative to the September and November bills.

Source: SSGA.

Given the impact that a US government default would have on Treasury market investors, it’s no surprise they would be among the earliest to brace themselves. However, it may also be time for equity investors to take notice of the potential trouble on the horizon.

Debt ceiling brinksmanship: A lesson from 2011

Failure to pass debt ceiling legislation before 29 September could have severe consequences; we know this from experience. In 2011, the US government hit the debt ceiling and forced the Treasury to suspend payments into federal retirement plans. The US also came dangerously close to default. While lawmakers cobbled together a stopgap deal two days before the Treasury was estimated to default, the debacle resulted in Standard & Poor’s downgrading the US credit rating for the first time. The agency cited “political brinksmanship,” which it said made the US “less stable, less effective and less predictable.”

The downgrade spooked markets, sending the VIX to 48—the only time the index has hit that level since the Financial Crisis—and drawdowns on the S&P 500 hit 18%.

Source: SSGA.

Don’t get caught unaware

Given the current levels of partisanship and the factions that exist within the Republican Party, the debt ceiling debate will likely be challenging. While it would appear that a Republican majority should be able to push through their agenda without a hitch, the GOP has historically opposed increasing the debt ceiling.

Even if legislation is reached in time, it will still mean valuable time has been taken away from delivering on the legislative promises—like tax reform—that have driven the post-election stock market rally.

As federal coffers dwindle, investors should keep a close eye on bond market movements and the potential for negative spillover into stocks. If the VIX were to revert to its 20-year average, that would imply a 98% spike from current levels. Having gone over 280 days without a drawdown of more than 5% on the S&P 500, the transition from a tranquil August into a contentious September could leave investors who are too lackadaisically positioned in the cold.

Don’t let the current tranquil volatility regime go to your head. It’s prudent to remain well diversified and positioned for whatever comes next. It might also be time to re-visit our 2017 Mid-Year Outlook, which highlights ways to position portfolios for a return of market volatility.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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