In its ‘year-forward’ 2017 outlook, JPMorgan’s Marko Kolanovic warns that:
In the short-term, with additional rate hikes imminent and the record level of the USD, we are at an increased risk of repeating the scenario from January 2016 where fundamental and systematic investors were selling at the same time in the aftermath of a Fed hike (albeit, some risks are lower this time, such as higher Oil prices and a lack of focus on China/CNY). According to our macroeconomic model, the VIX also appears to be ~3 points too cheap (1 standard deviation) relative to dozens of macroeconomic variables.
So what is driving the VIX and is it still a good measure of equity market risk? There are several factors that can explain the behavior of equity volatility this year. The first one is structural and we described it as market pinning during most of July and August, caused by option positioning. At the peak of market pinning in August, the S&P 500 realized less than 5% annualized volatility and moved less than 10bps on a number of days. As Brexit, the US election, and the September volatility spike were well anticipated events, they also resulted in covering of option hedges, and opportunistic selling of volatility. Low/negative bond yields increased the allure of selling volatility (and buying equities) and put further pressure on volatility levels. Finally, it appears that the time horizon of macro traders has shortened dramatically, likely as a result of increased participation of machines and algorithms that are quicker to adjust to significant events and can eliminate trading activity of slower investors (such as the overnight post-election move).
What will market volatility be in 2017? We think that, fundamentally, risks for equities in 2017 are higher compared to 2016. We expect an increased level of geopolitical risk and increased uncertainties related to the new US administration. In Europe, significant risks include fallouts from Brexit, the referendum in Italy, elections in France and Germany, and continued tensions related to immigration. The Middle East will likely see further turmoil in relation to developments in Syria, and low Oil prices that continue exerting pressure on budgets of Oil exporters. While the US macroeconomic cycle may get a boost from the proposed fiscal stimulus, corporate tax reform and de-regulation, both the passage and efficacy of these measures are far from certain at this moment.
The main market risk for equities will come from a stronger USD and higher rates, in our view, which can destabilize equity P/E, Emerging Markets, the housing market, and US equity segments such as multinationals, domestic manufacturing, bond proxies, etc. Higher USD and bond yields will also undercut the ability of the new US administration to revive US manufacturing or use the fiscal deficit to re-ignite growth.
Periods of low volatility may mask underlying fundamental risks. These quiet periods will be followed by quick outbursts of volatility that may not last long enough to be captured by an average investor. Hedgers may buy volatility ahead of an event and sell shortly before the catalyst to capture volatility grinding higher (rather than a spectacular increase).
To gauge market risks, equity investors should watch for further increases in bond yields and strengthening of USD. Geopolitical developments should be gauged from both traditional and non-traditional data sources (such as big data sentiment indicators, independent media outlets, etc.) given the failure of many traditional data sources to anticipate geopolitical developments this year.
So in summary – don’t trust the “fakeness” of a low VIX or the mainstream media when it comes to managing your money.