Since the summer, markets have been animated by sudden ups and downs suggesting a fierce battle is taking place between the bulls and bears of the investment world. Investment research is also indicative of a deeply divided investment world. So how can we better understand the situation? On both the economic and market fronts, signals are unclear. On the one hand, the "macro" while declining is still decent for the moment and central bankers have sworn off inflation, even if it comes at the cost of a recession. On the other hand, markets have fallen year-to-date by about 20% for equities and 9% for bonds, taking the performance of a 50/50 portfolio to a historic decline of 14% – enough to make any pension fund manager quiver. Even so, the VIX continues to hover around 20% and implied volatility has a fairly flat term structure, which is usually a sign of confidence for the future. How do we reconcile this investment puzzle? Let's review the key elements of the situation.

 

Answering both sides of the macro question

For equity markets to rise sustainably, interest rates must stabilise and corporate earnings must continue to rise. Stabilising interest rates requires central bank monetary policy to be less aggressive when inflation returns to its target value. We are not there yet. On the earnings side, results remain decent, driven by galloping inflation in Q2, which has served the large caps well. Investors must now ask themselves: how will rates and earnings behave over the next few quarters?  While we have previously sought to answer the first of part of this question, we have so far left the second part unanswered.

 

Anticipated growth is confusing

A simple way to answer the earnings question is to look at the most recent indicators of real economic growth, such as the ISM or Chicago Fed National Activity Index in the US, the European Commission's surveys for the Eurozone, or economists' expectations. Chart 1 presents a global view of these different elements transformed into expected growth for Q3 to make the comparison easier. The message is obvious: nothing is clear and growth expectations oscillate between negative and positive values. The "macro" uncertainty that now hangs over real growth in corporate earnings is high. While the apparent trend in our nowcasting indicators shows a deterioration in the economy, it is not yet possible to say that we are currently in a global recession.

 

Chart 1: Growth expectations for Q3 2022 in the US (left) and Europe (right)

Source: Bloomberg, LOIM

 

Investors are partially protected

On the market side, the implied volatility indices are extremely low for a period such as this. The VIX remains anchored between 20-25%, clearly underperforming the rise in credit spreads, as shown in Chart 2, and displaying a low skew. Yet, exchange volume reports show unprecedented put flows. How can we reconcile the rise in risk and hedging volumes when volatility indices remain so low? An explanation can be found in the market regime we’ve been experiencing for the last ten months: a slow motion crash (i.e. a drawdown that is not associated with high realised volatility, as would usually happen). This low volatility has meant that traditional hedging strategies (long puts, long vol or long tails) have not delivered what they were supposed to and most actually produced negative returns! This has prompted private and institutional investors to adapt their hedging strategies. Instead of positions aiming to hedge large declines using simple instruments, such as out-of-the-money puts, there have been large flows into more complex structures – i.e. those with multiple legs or exotic features – which aim to hedge smaller variations than usual, with a better control of costs. Combining buy and sell hedging structures has inflated hedging volume figures, which do not report "net" exposure but calculate buy and sell hedging figures indiscriminately. Let’s look at three examples of these “limited hedging” or “conditional hedging” structures. The first one is a put VKO (volatility knock-out): the hedge completely disappears if volatility is realised over a specified level. The second one is a put D&O (down and out): the hedge completely disappears if the spot goes below a certain level. The third one is a put DKO (double knock-out): the hedge completely disappears if the daily return goes above or below a specified level. In these three cases, we’re referring to hedges that do not represent a net demand for volatility or skew.

Thus, a low VIX is not necessarily a sign of complacency on the part of investors amid rising macro risks. It is a sign that the market is prepared for the decline to continue without volatility but is not prepared for larger shocks and that is where the risk now lies. Should the macro situation significantly deteriorate as winter comes, “two sigma” moves could catch investors on the wrong footing.

 

Chart 2: CDX IG spreads versus VIX

Source: Bloomberg, LOIM

Simply put, markets are now facing macro uncertainty and an ongoing decline without volatility; investors are currently hedged against this scenario rather than more extreme risks.

---

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.

Our nowcasting indicators currently point to:

•    Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum while the most recent data shows that this deterioration has room to go.
•    Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US. 
•    Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected.

 

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 gather 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).