The disappointing volatility hedge

In the latest instalment of Simply put, we consider the conundrum faced by investors this year in light of declines for both equities and bonds and examine why long equity volatility strategies are failing to provide effective hedges in this environment.  

Many commentators have called 2022 the worst start to a year for equities and bonds alike. What commenced as a bearish rotation has become a bear market with the rotation causing many portfolios to suffer – especially passive variations around a 50/50 portfolio. The low rates environment has led to very concentrated passive indices, while pushing duration to its maximum. The bonds/equity correlation breakdown has added a final blow to this horrific situation: on average a 50/50 portfolio has lost 11% year-to-date as of mid-May (based on MSCI World and Bloomberg Barclays indices). Despite a general perception to the contrary, there are usually places to hide in such circumstances. Derivatives and tail hedging solutions can offer more than a good chance of softening such market blows, and long equity volatility positions are representative of such strategies. Only this time, these strategies have failed to offer the expected shelter. What has happened and should we move away from these hedging strategies?

A significant difference exists between statistical hedges and explicit hedges. Explicit hedges are derivatives-based hedges targeting the protection of portfolios during pre-determined scenarios. The most naïve example of this uses a put option to explicitly protect a portfolio in the event of an equity downturn. The hedge is mechanical and, should the risk materialise, the protection is certain. Such protection comes at a cost (the option’s premium), which is generally less explicit for statistical hedges. For example, when building a basket of commodities futures, one would seek to protect this portfolio against the risk of inflation statistically, meaning that the hedge should work if historical correlations hold true in the future.

Long volatility strategies stand in between statistical and explicit hedges and investors have grown accustomed to using them, especially on the equity side. Such strategies seek to deliver returns when implied volatilities rise, which generally happens as equity returns decline and coincides with the moments when put options see their prices rise. However, since the start of the year, such equity strategies have delivered very disappointing returns. The reason for this is largely due to the fact that volatility – as measured by the VIX index – has not spiked enough and, when it has, this has been mainly around its front contracts so that investors have not felt the impact of its protection. Many see the absence of a strong VIX reaction as a lack of “capitulation” by bullish investors, who have not yet been yielded to the equity decline and are preventing the VIX from exploding higher. A similar case can be made with CDS indices, which have also failed to spike as much as they did in 2020, for example. Chart 1A illustrates this point for the VIX and the V2X indices, highlighting how derivatives-based hedges are pricing a scenario more like 2018 than 2020; Chart 1B emphasises the relative lack of reaction of the VIX term structure compared to recent market stress events. So, have these strategies stopped working?

Chart 1A. & Chart 1B.

 

Answering that question boils down an assessment of whether the VIX’s reaction to the equity drawdown has been consistent with history. Chart 2 illustrates this point by comparing variations in the VIX index with the magnitude of historical equity drawdowns (based on the S&P 500) over rolling 4-month periods. The chart highlights that this relationship is non-linear: as an equity drawdown accelerates, the VIX tends to react disproportionally to that shock. On a percentile basis, the 2022 VIX reaction actually seems to be very consistent with the current equity drawdown, as well as a couple of comparable downturns during the post Great Financial Crisis era, as shown on the chart. In our view current frustrations can be explained by the short-term nature of the shock: essentially, front-end contracts have risen but the longer-end of the curve has barely moved.

Chart 2. Scatterplot comparing VIX variations and returns on the S&P500

Source: Bloomberg, LOIM

An absence of diversification from the bond element of a 50/50 portfolio is behind further investor frustration. We think this scenario would be eased significantly if a long equity volatility strategy was combined with a long rates volatility strategy. Since both equities and bonds are declining, a combination of both types of volatility strategies is essential to efficiently managing this type of global correlation shock. Across our investment solutions, the “volatility” bucket had a zero return this year as gains for our rates volatility strategies offset the losses faced by our equity volatility strategies. Interestingly, during the recent episode of market stress, our drawdown management techniques have also proved useful in protecting our portfolios at a time when most risk premia have lost ground.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

In the US, the growth picture remains strong, giving more room for the Federal Reserve (Fed) to deploy its hawkish policy. Retail sales and industrial production posted strong numbers, reaching levels which are far from being consistent with a recession – yet. In moving average terms, as shown by our Nowcaster growth chart, both are growing at a pace which is much stronger than that of the past 10-years. Retail sales grew by 0.9% in April versus 0.5% in March. Industrial production’s growth of 1.1% beat expectations, which forecast a rise of 0.5%. These are “hard data”, meaning they are macro data which measures past situation. Timelier data such as manufacturing surveys, however, are showing a decline. The Empire manufacturing survey declined from 24 to-11 (expected at 15) which likely reflects the slowing economic conditions in China. The Philadelphia Fed survey dropped from 17.6 to 2.6, a lower level that is still consistent with decent growth. At the opposite end of the spectrum, the capacity utilisation rate remains on a rising path: capacity utilisation rose from 78.3% to 79%, yet another sign that growth in the US should remain strong in the near future. Another positive signal is the ongoing strength of the US housing market. Pending and new home sales remain set on an uptrend, which could further force the Fed outside of its comfort zone. 

In the Eurozone, GDP numbers remain elevated: Eurozone GDP rose by 0.3% versus 0.2% expected in quarterly variations terms. This brings the year-over-year variation to the high level of 5.1% (versus 5.0% expected), the Eurozone has been enjoying strong growth momentum over the past 12 months. Construction output paints a similar picture: the latest number showed 0% growth, but the moving average of this very turbulent number remains on an uptrend. The housing market in Europe, as in the US, seems to be very solid.

In China, housing prices remain set on a downtrend and are nearing the trough of 2015. Recent stimulation by the central government and the People's Bank of China (PBoC) are starting to show in the data: investment numbers posted a recent pick-up, fixed asset investments rose by 6.8%. On the flip side, retail sales still show the consequences of the pandemic, declining in year-over-year terms by 11.1%, worse than estimates which expected it to reach -6.6%. 

Factoring in these new data points, our nowcasting indicators currently point to:

• Worldwide growth remaining solid. The US and the Eurozone are still showing high numbers, but these numbers are now clearly declining in the Eurozone. This slowdown is essentially the result of falling consumption levels.
• Inflation surprises should remain positive but our signals have shown a recent decline. In the US, this has brought the indicator closer to its neutral zone, as costs and housing data should now translate into lower inflation pressure.
• Monetary policy is set to remain on the hawkish side, mirroring the strength of activity. The Fed has again confirmed its hawkish stance – the European Central Bank should be next.
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)
   
World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gathers economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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