Simply put: macro uncertainty could drive market volatility

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.

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

¹ 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.

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