As a mental exercise, try reconciling the following sets of facts: Since the February lows, global equities have rallied nearly 15 percent, emerging market stocks by 20 percent, WTI crude by approximately 35 percent and equity market volatility has fallen by over 50 percent. But during that same period, emerging market economic data has consistently disappointed, earnings have remained challenged and one of the best measures of U.S. growth is stuck in negative territory.
To be fair, there are credible explanations for the recent rally. China’s currency has stabilized, the U.S. labor market continues to expand, and the oil supply appears to be moderating.
But most importantly, central banks have added still more stimulus. To my mind, it is the last development that matters the most. Apart from more monetary pixie dust, it is not obvious that the fundamentals have improved as much as the drop in volatility suggests.
Historically, equity market volatility has been driven largely by financial market conditions and expectations for growth. When growth becomes too sluggish, often a precursor to a recession, volatility is generally higher. Even more importantly, when credit markets are struggling, equity markets rarely remain immune. Therefore, it is worth considering whether either has improved enough to justify the sharp reversal in investor sentiment:
Growth has stabilized in the U.S. but remains a risk elsewhere
In the United States, the economic data suggest stabilization, but not acceleration. My favorite leading indicator, the Chicago Fed National Activity Index (CFNAI), has been negative for six of the past seven months. Meanwhile, despite rebounding a bit in March, European economic surprises have turned negative since January, while a similar emerging market index has collapsed.
Financial market conditions are looser, not loose
High yield (HY) spreads—the difference between the yield of a high yield bond and a Treasury note of similar duration—are down 2 percentage points from their February peak, as investors buy high yield bonds. Moreover, real (after inflation) interest rates are below where they started the year and the dollar is weaker, a de facto monetary easing. However, it is worth highlighting that conditions are still far from easy. HY spreads remain above average and roughly 200 basis points wide from their 2014 lows. Most broader measures of financial stress have followed a similar pattern: a significant improvement from the February peak but still indicating some pressure.
All of this tells me that conditions have improved, but not enough to justify the sharp drop in volatility. Equity volatility, as measured by the VIX Index, is roughly 30 percent below its long-term average. That appears inconsistent with a still murky growth outlook and less than benign credit markets.
Does this mean that volatility needs to rise? Not necessarily, but to remain at these levels you need to assume central banks will continue to lean aggressively towards accommodation. While this is technically possible, it is becoming more difficult. As we’ve recently witnessed, some monetary prescriptions, notably negative interest rates, come with unwelcome side effects. Also, as investors have come to expect more stimulus, or in the case of the Federal Reserve a glacial tightening pace, it becomes more difficult to provide a positive surprise. In addition, it will be harder to lift valuations from these levels; developed market P/E ratios have reverted back to their 2015 highs.