Equity and currency volatility both have dropped since last October as recession odds faded and a soft landing became increasingly likely. Lower asset price vol is to be expected as tail risk fades and the economic backdrop becomes less uncertain (HERE). Equity volatility will remain reactive to inflation releases, Fed speeches, and data that have a large impact on the policy outlook, but a lower level of vol than has been seen over the past few years should be expected.
Bond volatility remains elevated, reflecting uncertainty about the Fed rate path. Treasury vol has eased recently, and spreads are tight, apart from mortgages.
During historical economic expansions, which we sub-classify as Normal and Growth regimes, equity volatility has typically been around 16. In periods of heightened macro uncertainty, median VIX readings are around 23. Macro data that suggest stronger inflation or a crashing in growth could shift implied vol to a higher average level. Vol spikes in the absence of those data remaining opportunities to add to risk.
With lower volatility comes lower S&P correlations. S&P 500 correlation has been steadily declining across mid and large caps, and small cap correlations have fallen sharply since late February. At the same time the spread between Russell 2000 volatility and large cap volatility has narrowed rapidly to ~ its 75th %tile. Smaller caps are trading less as a group than they did following the 4Q rally, but there is still more opportunity to find relative out/under performers.
Within S&P industry groups, more than two thirds have seen lower correlations over the past month and week. Tech Hardware correlation dropped most recently, leaving its short-term correlation unusually negative. Within Semis and Software, correlations remain higher than most industry groups, but normal relative to history. Energy correlations have been dropping as well, making stock picking more effective within the group.
Volatility & Correlations Still Biased to Remain Low: Equity and currency volatility both have dropped since last October as recession odds faded and a soft landing became increasingly likely. Lower asset price vol is to be expected as tail risk fades and the economic backdrop becomes less uncertain. Bond volatility remains elevated, reflecting uncertainty about the Fed rate path. Treasury vol has eased recently, and spreads are tight, apart from mortgages. We expect equity volatility to remain lower than over the past few years (HERE). Spikes around major macro data releases (April 5th payroll, April 10th CPI) should be expected. Unless data changes the path of policy, those spikes remain opportunities to add to risk.
Equity volatilities vary wildly under different macro regimes. Under Normal and Growth regimes, which we are currently in, median implied equity volatility has been ~16. Median readings for Transitions and Recessions were >23. Fed rate uncertainty could shift equity vol higher IF data suggest stronger inflation or a crashing in growth, but the current trends support a low avg VIX.
Macro conditions steadily improved over the past few quarters, reducing downside tail risk. Implied vol has gradually moved lower, reflecting reduced uncertainty as growth slowed and inflation shifted lower.
Low implied volatility is partially a function of lower correlations. Both the short- and long-term correlations are low today. With the S&P PE ~22x and yields rising, a lower risk premium is likely needed to drive the overall market meaningfully higher. Lower correlations mean more opportunity to outperform using factor, industry group, and stock selection.
Across different market caps, the S&P 500 now has the lowest correlation on a 1 month and 6 months basis. Short term correlations of small caps have dropped sharply since late February. Over that same time period, a simple strategy of buying profitable small caps and shorting unprofitable names (MS22LPSU Index on bbg) has gained 4.5%.
There was an extreme spread between large and small cap volatility earlier this year, measured through the spread between RVX Index and VIX Index). It peaked in mid-February. Small cap volatility dropped more than large cap volatility as well. That suggests investors are growing less concerned about shocks that would impact smaller caps as a group.
Within the S&P industry groups, more than two thirds have seen lower correlations over the past month and week. Tech Hardware correlations dropped the most and are now exceptionally low. Auto, Media, and Communication Services correlations have increased but remain at normal levels. The bottom line is stock picking and factor analysis remains much more valuable than it has been over the past few years.
Tech Hardware correlations have turned unusually negative, suggesting more stock return divergence within the group and more opportunities for stock picking. The other two Tech industry groups – Semis and Software – still have relatively high correlations, but their absolute level are about at their normal level. Energy, which used to have the highest correlations are now lower as well, reinforcing the opportunities within commodity cyclicals.
