13 Feb 2018
Volatility is back. After more than a year of record calm in stock markets, the VIX index of S&P 500 volatility briefly hit 50 as it exploded upwards last week.
It has since settled closer to 25, still higher than we’ve seen recently but closer to its long-term average. The sheer quantum of this leap can probably best be explained by a “short squeeze” on a relatively sizable cadre of derivative investors. Over the past 12 months more and more money began to short the VIX – to bet that it would go lower. However, when volatility popped higher, investors suddenly needed to close out their trades by buying the VIX index or were forced to sell their short position by brokers calling in margin loans. This situation creates a snowball effect that quickly gathers pace. Now, after a year of all that money weighing down S&P 500 volatility, those short positions evaporated almost overnight. Long positions on volatility now dominate once again. This is important for equity markets because implied volatility (the VIX) is pivotal in the valuation of options, which can in turn impact equities (as we have seen).
Last week was nerve-jarring as markets jumped about erratically. A wave of selling would move steadily from time zone to time zone before a wave of buying would follow. Once the commotion was over, equities had given back all their 2018 gains. Asia was hardest hit, with the Shanghai Stock Exchange Composite and Topix down 9.6% and 7.1% respectively in local currency terms. The forward P/E of the S&P 500 is now 16.5x, compared with more than 18x just a month or so ago. This level is more or less in line with the market’s long-term average.
As the year progresses and central banks continue to tighten monetary policy, we believe episodes like we’ve seen will crop up again. Setbacks always feel more jarring after a period of calm, and the latest calm stretch is unrivalled in history. We think we are closer to normalcy after a strange period, rather than entering something dark and terrible. Stock markets are susceptible to rising discount rates (although less so now after the retrenchment), but the global economy should be able to deal with the cautious tightening likely from central bankers. Growth is strong, company earnings are healthy and consumers in the US, Europe and China – accounting for much of the world’s GDP – are buoyant.
Source: FE Analytics, data sterling total return to 9 February
All eyes are on inflation now. UK CPI was forecast to drop slightly to 2.9% when it released on Tuesday; US inflation is expected to fall 20 basis points to 1.9% when it’s released on Wednesday. If these numbers surprise on the upside, expect markets to get jittery again. Still, if they do, we believe it would be simply a short-term move. Besides, we would argue underlying inflation in the US is actually worryingly low, not worryingly high.
A simple macroeconomic model has suggested that a pickup in wage growth was coming down the pipe for a while. In fact, it tells us it could go higher. But it is important not to invent a strong relationship between higher wages, price inflation and interest rate policy that simply isn’t there. The death spiral of higher wages driving up the price of goods and services which in turn leads to ever higher salaries and an inflationary feedback loop is ingrained in the public consciousness. But it’s a zeitgeist from a different time. During the last wage-price spiral in the 1970s, the workforce was much more unionised meaning a solid bloc of workers’ pay was pegged to inflation. That has not been the case for some decades now. Policymakers at the Federal Reserve (Fed) have expressed more and more scepticism about the pass-through from wages to inflation. The correlation between wages and inflation has been exceptionally weak, and the response of wages to low unemployment in the US has been tepid at best (see more on this relationship in our recent research report Under pressure?).
The acceleration in wage growth which drove the recent market panic wasn’t broad based either. Production and less senior staff didn’t enjoy the same uplift as managers, and the inflation-adjusted wages of part-time workers – who account for almost one in five of the workforce – are falling. Wealthier earners are more likely to save extra income and so don’t present quite as much of an inflationary threat. We believe wage growth would have to shift up rather more dramatically to cause the Fed to put a squeeze on the business cycle this year.
The Fed has a mandate to maintain stable price inflation, and is most likely to respond to prices that it can actually do something about. Energy and food prices are beyond the control of any central bank (at least one operating in an open economy) and costs relating to housing can take an awfully long time to adjust. When we strip out these three sectors, consumer price inflation is running at a paltry 0.7% – worryingly low, not worryingly high.
UK 10-Year yield @ 1.57%
US 10-Year yield @ 2.85%
Germany 10-Year yield @ 0.75%
Italy 10-Year yield @ 2.05%
Spain 10-Year yield @ 1.48%