Vix causing its own fear

The Vix “fear gauge” appears to be creating its own fear factor as it falls to new lows. The Vix has traded over the past few days at levels last seen in 2007, giving journalists the opportunity to draw comparisons between now and that historic time in the global economy. On Tuesday, the FT claimed that the central banks have been responsible for extinguishing volatility. The Vix relates to the expected volatility in equity markets, but volatility expectations have also fallen in other asset classes such as bonds, oil and currencies, according to the FT. George Magnusson, a well-known economic strategist, was quoted in Tuesday’s FT, warning that 2007 ended with extreme volatility and this period of calm may do so as well. Having worked with Mr Magnusson many years ago at Warburg’s, where he correctly predicted the 1987 sell off, one takes note of his words. His measure of risk for the equity market rally in 1987 was the gap between the equity yield and bond yields. This is important, as equity valuations are partly a function of bond yields. In 1987, equity indexes were yielding less than half of the then current 10-year bond yield. The market was effectively not pricing in enough risk in equities. Today is very different, as bond and equity yields remain in the same ball-park. As Mr Magnusson points out, volatility will rise eventually, however history has shown that volatility can stay at subdued levels for some time, so the question remains, when?

A low Vix reading is often considered a sign that investors are becoming complacent. The contra to that point is that, at the moment, investors may be showing a degree of confidence in a period of calmness following several years of volatility. It is not uncommon or unreasonable for people to question the longevity of an equity market rally, in fact it is probably healthy. We would suggest that investors are far from complacent at this point in time, but instead are rather vigilant and cautious. Our belief is while bond markets remain stable, equity markets will take reassurance; however, any sharp rise in broad volatility will almost certainly be preceded by volatility in the bond market, which is where we keep our focus.

On Wednesday, the World Bank cut its global GDP growth forecast for 2014 from 3.2% to 2.8%, which resulted in the equity markets taking a breather for a day. The reasons for the cut: Ukraine; poor weather conditions at the start of the year in the US; Turkey; and China amongst others. Most of those reasons would appear historical or at least temporary. China data is improving, the US is warmer and the situation in the Ukraine seems to be improving. Therefore, one has to question whether, like many economists before them, the World Bank looks backward and not forward.