investment viewpoints

Simply put: macro uncertainty could drive market volatility

Simply put: macro uncertainty could drive market volatility
Florian Ielpo - Head of Macro, Multi Asset

Florian Ielpo

Head of Macro, Multi Asset

In our latest multi-asset macro update, we share the following views:

  • Markets have recently been more volatile, especially the commodity markets.
  • This volatility echoes the more turbulent economic backdrop – which is evidenced by the extraordinary dispersion of economic indicators.
  • Over the next few weeks, overall market volatility may temporarily increase until the investment world agrees on where the economy is heading.

 

Global markets have recently been more volatile than they were in the first half of the year. This volatility reflects a significant number of phenomena, with investors' attention deviating across a number of issues: the Evergrande1 situation in China and an apparent energy crisis coinciding with the beginning of autumn, to name two. Volatile, if not contradictory, economic data form another factor gradually being added to the news tumult. Macro volatility and market volatility have traditionally been related, but is that still true today?

In 2012, Robert Engle and his co-authors’ paper, "Stock Market Volatility and Macroeconomic Fundamentals", presented a model aimed at decomposing market volatility into daily and long-term components, with the latter being linked to macroeconomic fundamentals, such as industrial production growth and inflation. This study – extending from the 19th century to the beginning of the 21st century – found that a more volatile economic environment generally unfolds with a more volatile market environment. Today, markets have a marginally higher level of volatility: so is this a reflection of a more turbulent economic backdrop?

 

Measuring economic volatility

Most economic data is issued on a monthly basis. This means that measuring the volatility of monthly economic indicators is backward-looking and it takes time to collect enough observations to establish whether volatility is evident.

However, there is an alternative way to achieve the same objective more quickly: analysing the dispersion of different components within a single survey. This dispersion can be calculated using the standard deviation of the variations of the different components of each survey for a given month. This helps answer a simple question: are all of the components moving in the same direction? If not, ‘macro’ volatility is increasing. Such an analysis can be done, for example, with the ISM manufacturing survey (which contains 60 sub-components) or the US Consumer Price Index (which contains 312).

Here, the US can represent what is happening around the world. Figure 1 presents US growth and inflation dispersion (similar results could be achieved using the European Commission's surveys or with the various Chinese PMIs).  As shown on the chart, macro dispersion is rising sharply; while this rise in growth is mainly due to the COVID-19 crisis in 2020, the chart shows a slight increase more recently, following a period of decline. On the inflation side, the indicator has spiked recently, reflecting the turmoil we are currently seeing around this theme.

We can therefore make the following observations:

  • Recent weeks have been turbulent for both inflation and growth
  • The level of growth uncertainty (weaker than that shown by inflation) has become more prominent
  • Inflation uncertainty is at record highs but shows initial signs of decline

 

Chart 1. Macroeconomic dispersion measures for US economic activity (left) and inflation (right), 1954-2021.

 

Multi-Asset-simply-put-Oct_21-01.svg

 

Source: Bloomberg, LOIM as at October 2021. For illustrative purposes only.

Reading note: These graphs show the evolution of the dispersion in the subcomponents of the US manufacturing ISM and in the subcomponents of US inflation (CPI). This dispersion is calculated using the standard deviation for a given date of the changes in the subcomponents. The period is from January 1954 to September 2021.

 

Echoes of the 1970s

In our view this uncertainty about growth is an important element and perhaps reflects more than is initially apparent. Not only are the data volatile, but they also betray the heterogeneity in the survey – some components are progressing, while others are declining. Yet inflation is where the dispersion is greatest, and we have to go back to 1975 to find a similar level of dispersion.

In 1975, core inflation rose sharply, following a rise in energy inflation in 1974. Headline year-over-year CPI in 1974 was 12.3% and core inflation reached 11.7% in February 1975 as a consequence. During this period, equities and real rates rose, while commodities stabilised. The similarity between this period and the current environment is interesting: both feature a progressive rise in market volatility (as shown by the S&P500 in figure 1), and this turbulence has not necessarily indicated that conditions are deteriorating. In 1975, equities continued to rise as inflation became less volatile.

 

Sources

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

 

Simply put, the macro environment today is uncertain, although we believe that growth should remain strong and inflationary forces are likely to stabilise in the coming months. However, we would not be surprised to see market volatility increase temporarily during the coming weeks.

 

important information.

This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited  which is authorized and regulated by the FCA. ©2021 Lombard Odier IM. All rights reserved