Goldman: “Periods Of Low Vol End In Tears… The Biggest Risk Is Central Banks”
One month ago, unleashing the latest series of warnings that the current period of low volatility will not have a very unhappy ending, came from Bank of America, which said that “These Markets Are Very Weird.” A few weeks later, JPM’ Marko Kolanovic warned that complacency will end in “catastrophic losses“ for short vol strategies followed promptly by Deutsche Bank’s Aleksandar Kocic who demonstrated that there is no scarcity of scary adjectives when he likewise warned that the current period of market “metastability” will showed lead to “cataclysmic events.” Now it’s Goldman’s turn.
In a note by Goldman’s Christian Glissman seeking to explain “The upside of boring – risks and asset allocation in low volatility regimes”, the vol strategist joins the bandwagon and writes that while “low volatility periods do not have to end in tears, they often do.” His explanation:
Volatility tends to cluster and is often low for a good reason – this indicates investors should add risk during those periods. However, a prolonged low vol period can also eventually result in excessive risk taking and latent risks from elevated valuations. But moving out of a low vol period does not have to come with a material ‘risk off’, at least initially. Usually volatility tends to spike and equities settle into a higher volatility regime first (Exhibit 37) and the average drawdown is less than 5%.
Markets often enter a higher vol regime before there are larger equity corrections, usually 6-24 months later (Exhibit 38). This suggests a more gradual risk reduction as markets shift into a more persistent higher volatility regime as the macro backdrop worsens. Currently, we see little recession risk in the next 12 months although growth momentum may have peaked and the US economy is moving more late cycle.
So if not a recession, what could unleash more images of traders with hands on their faces? Here Goldman channels the latest note by Matt King, and says that the “bigger risk could prove to be central bank tightening, which could drive more volatility in the near term, especially owing to the elevated uncertainty around the balance sheet runoff by the Fed and ECB.”
Further, volatility can spike due to unexpected shocks and tail events – with higher vol of vol risk, running increased cash allocations and some tail risk protection appears sensible. This is particularly true as valuations across risky assets remain high, resulting in poor asymmetry for LT returns.
The shift from a low volatility regime to a higher is shown below:
There are other dangers too, for example low volatility masking correlation risk in multi-asset portfolios.
In multi-asset portfolios, investors might face further risk based on the premise of diversification. Absolute cross-asset correlations tend to increase with higher volatility (Exhibit 39). This is especially a risk for risk parity funds and volatility target funds which often increase risk based on volatility by asset class and on a portfolio level. Since the 1990s bonds have provided hedges for equities in periods of higher volatility, allowing multi-asset investors to run higher risk/leverage levels. But right now, as both bonds and equities appear expensive, bonds may be less good hedges for equities in drawdowns, and there is the potential for negative rate shocks to weigh on equities, as central banks tighten policy. Commodities have helped in high inflation periods like the 1970s but they have been more a source of risk recently, with large oil price declines and still-low inflation.
So why not just go long vol? Well, in a world of BTFD the theta is simply far too great. The result: everyone is shorting vol instead, even though “Short vol strategies are becoming riskier.” For more on this, see the latest Kolanovic note.
Unsurprisingly, short vol strategies tend to very profitable in low vol periods, while being long vol tends to be costly. Exhibit 41 shows that being long vol through the VXX (long shorter-dated VIX future ETF) has been very costly since 2011 – the VXX is down 99% since then. It is not just low realised S&P 500 vol but also the contango in the VIX futures curve (in-line steep equity vol curves) that creates a painful rolldown, even if volatility is unchanged (see Navigating the VIX ETP market, April 25, 2017). VIX options can be a better way to position for a rise in the VIX.
As the VIX spikes revert rapidly, it has also been particularly difficult to capture ‘risk off’ episodes through a long VIX future position recently. On the flipside, this has made short vol a popular (and profitable) carry trade; for example, the XIV (short shorter-dated VIX future ETF) has nearly tripled since the beginning of last year. As a result, the net and outright short position in VIX futures is at all-time highs. But the risk of short vol strategies in most markets is clearly rising. For example on May 17, 2017, following to the VIX spike due to concerns on the impeachment of President Trump, the XIV was down 18%.
Taking all of the above, Goldman’s advice: go to cash, and reduce risk.
This further strengthens the case for increased cash allocations and also for broader diversification. Alternatives such as real estate and private equity can help, although they often introduce liquidity risk in the portfolio and also carry equity and duration risk. Generally, a more momentum-based investment approach can help manage risk-adjusted returns in periods of rising volatility – with declining momentum in risky assets in low vol periods, we believe investors should further reduce risk.
One last chart: according to Goldman calculations, 1-month S&P500 realized vol now finds itself in the 0%th percentile. It has never been lower.