Beneath the surface, dispersion and uncertainty loom

In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we explain why current low levels of volatility underplay the true state of market uncertainty.  

As 2021 comes to a close, we can begin to draw some conclusions. Overall, market performance was positive (around 16% for MSCI World), volatility was low and growth prospects remain solid. While most investors were able to benefit from these supportive market conditions, underlying angst continues to hover over our heads as uncertainty remains despite the positive backdrop.

The volatility of returns offers one interpretation of market risk: that volatility tends to be negatively correlated to equity performance. Chart 1 represents the 30 days realised volatility of the S&P 500 Index since 2009. The levels observed in 2021 were well within historical averages, and the recent reading remains low (about 12%) even though greater risk aversion has been triggered by the Omicron variant. This suggests the market holds a higher sense of certainty for what is to come. However, this measure does not paint the whole picture, conveying just one of several messages: while earnings growth remained solid throughout 2021, other sources of risk have been stubbornly persistent.

Chart 1. Realised volatility (30 days) of the S&P 500 Index

Source: Bloomberg, LOIM.

Dispersion gains ground

Below the surface, the picture appears murkier. Chart 2, which looks at dispersion, represents the difference between the 30 days realised volatility of the S&P 500 Index and the average 30 days realised volatility of the top 60 stocks within this index (a similar computation using the whole investment universe shows comparable conclusions). Today, while overall index volatility has remained within historical averages, its dispersion has increased to levels above the historical average.

In our view, the market is experiencing a type of “windscreen wiper” effect, as every day/week/month brings about the unwinding of the previous day/week/month’s sector rotation. As uncertainty increases, investors are having trouble predicting which factor will benefit from the current conditions. The striking result shown on Chart 2 echoes the relative performance of value versus growth, financials versus healthcare or emerging markets versus developed market. Dispersion is not only found in this volatility measure, but also in the relative levels of performance.

The challenge of correctly deciphering the overall winners is a clear sign that uncertainty has increased. This is confirmed by the fact that dispersion has been gaining ground since 2019. In addition, this dispersion metric has recently sat at the 99th percentile (in the context of the last 12 years) – a sharp contrast to where index volatility sits today.  This reflects the dispersion seen within inflation subcomponents.

Recently, uncertainty has essentially been driven by the following three sources:

• Covid-19, which initially sparked surprise followed by unpredictable patterns
• Inflation worries
• Evolving central bank policies.

Chart 2. Spread between the average realised volatility of the S&P 500 Index and its subcomponents

Source: Bloomberg, LOIM.

The lack of persistent momentum in the sector rotations seen this year suggests that the violence of these moves are less visible when only scanned through low-frequency and aggregated data. Higher-frequency indicators can paint a widely different picture, be it from a market or macro perspective and with higher granularity than usual (potentially beyond sectors and styles). The prevalence of uncertainty these days, for the investment world, makes this scrutiny essential: it has become necessary to fully understand the current macro-structure of the equity market in order to potentially benefit from it.

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