Low stock market volatility masks ‘pain under the surface’

Even as traders grapple with a slowing economy, banking turmoil and geopolitical worries, stock market volatility in the U.S. is hovering around its lowest level in more than 20 months. With so much uncertainty and turbulence, why have price swings in the equity market been so subdued?

On the surface, the so-called fear gauge doesn’t seem very fearful: The Cboe Volatility Index, or VIX, fell to 16.5 on April 19, the lowest level since the end of 2021. The index’s drop partly comes down to surprisingly buoyant economic data, says Christian Mueller-Glissmann, head of asset allocation research within portfolio strategy at Goldman Sachs. While investors are concerned about the risk of a U.S. recession, the actual economic data has been sound. Employment and consumer spending have been strong, and historical modelling shows that the health of the labor market is a key determinant of equity market volatility, he says.

At the same time, inflation is showing signs of cooling. The sudden and unexpected concerns about stability in the regional banking sector, meanwhile, upended up traders’ expectation for rate hikes by the Federal Reserve — pricing in financial markets now suggests traders expect the central bank to cut interest rates later this year, Mueller-Glissmann says. That’s a switch from 2022 when inflation was climbing for much of the year and central banks were aggressively raising interesting rates to cool the rise in prices and wages.

 

“The market is transitioning from a period where the main concern for equity investors was how quickly interest rates were going up,” he says. “Now central banks are close to the end of their tightening cycles. You see inflation coming down. The concern about U.S. regional bank stress has moderated. And to some extent you’re still dealing with good growth and that anchors volatility.”  

While stock market may seem relatively placid, the banks stress that started with Silicon Valley Bank spurred investors to make a series of changes to their portfolios. Bonds rallied in price, buffering the drop in equities, Mueller-Glissmann says. As bond yields fell, that triggered a shift from domestic, cyclical stocks, like those in the Russell 2000 Index of small capitalization companies, to faster-growing large capitalization tech companies in the Nasdaq Index (whose profits may be further in the future, or longer in duration). “The market also treated the U.S. regional bank stress as a domestic shock that’s not impacting the large-cap multinational companies that dominate the equity index,” he adds. “There was a lot of pain under the surface.”

Mueller-Glissmann doesn’t expect low volatility to last all year. A big reason is that a longer period of lower volatility usually comes with a perky economy. By contrast, Goldman Sachs Research expects U.S. GDP to expand 1.6% in 2023, which is below its historical trend, and growth is likely to slow from here. Credit tightening due to the U.S. banks stress is likely to weigh on growth for the rest of the year. “Below trend and slowing growth is not consistent with equity volatility being significantly compressed,” he says.

Bond market volatility has also declined after a major spike following the collapse of Silicon Valley Bank. The MOVE Index of options linked to Treasury bonds soared last month to some of the highest levels ever recorded. Traders who were braced for the highest Fed funds rate in more than a decade were faced with the whiplash of having to account for a central bank coping with financial stability concerns, Mueller-Glissmann says. The rapid shift in positioning caused a spike in the index as investors thought the Fed would likely cut interest rates if banking stress became severe enough.

Even though the VIX, a measure of the expected 30-day volatility of the S&P 500 Index, may seem low right now, Mueller-Glissmann says that doesn’t mean derivatives investors are being complacent. They are mindful of the cost of options hedging, and they’re not necessarily concerned enough about growth, just yet, with no clear catalysts to justify that expense, he says. “That contributes to the VIX being a little bit lower,” he says. In addition, U.S. companies are reporting first quarter earnings, which tends to lower volatility as the micro data dominates the macro.

Investors are, however, increasingly concerned about political wrangling over raising of the U.S. debt limit, and Mueller-Glissmann says there’s an uptick in demand for hedging around potential debt ceiling dates. The deadline for raising the borrowing threshold is forecasted by Goldman Sachs Research to be reached in late July, although there is uncertainty on timing and the corresponding market reaction. Given the struggle to pinpoint the exact deadline, it’s difficult for options traders to buy protection to hedge that event, Mueller-Glissmann says.

And just under the surface, investors are making some important adjustments. The VIX curve is upward sloping, which is a sign investors expect volatility to increase in the future. The cost of puts has gone up relative to the price of calls (puts are a bet that a security will fall in price; calls are bet in the opposite direction). “The market is starting to be more worried about downside risk than upside risk,” Mueller-Glissmann says. He points out that financial markets are still in the early stages of focusing on concerns about economic growth, and there are signs that some investors are tilting their portfolios toward higher quality stocks, cash and bonds. “We certainly have seen people shift a bit more defensive in their portfolios,” he says. “Convictions levels are low, but people are feeling bearish.”

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