Within the last week, we’ve read about threats of another war in the Middle East, collapsing currencies across emerging markets, imminent rumblings of yet another Greek bailout. As of this writing, there is one day left until the Fed’s much anticipated pronouncement on the “end” of QE. Talk abounds of September being the worst month for stocks; October’s record is blackened with crashes. And yet: yesterdays’ close of 14.16 for the most widely followed barometer of fear, the CBOE Volatility Index (VIX), is close to a third below its 10-year average. Has the VIX, the vaunted “fear gauge,” ceased to reflect true market anxiety?
It’s worth pointing out that VIX markets are not predicting an easy ride forever. The VIX index represents a blended expectation of S&P 500® Index volatility for the next 30 days; futures on the VIX Index extend the forecast to supply longer-term volatility expectations. As shown above, these futures prices increase steeply to a level in line with VIX’s 10-year average. Given that this 10 year interval includes both the “great moderation” of 2003-2008 as well as the subsequent five years since the bankruptcy of Lehman Brothers, the bigger picture for volatility seem neither particularly bullish or bearish.
In the past few years – characterized by alternating risk-on, risk-off dynamics – the VIX has been a remarkably effective proxy for optimism or fear across multiple international markets. Five years on there is growing evidence that investors’ formerly incontinent risk appetite is becoming more discriminating. A case in point is provided by comparing U.S. and emerging market equities: the current correlation (0.56) is above levels prevalent prior to the crisis, but well below the majority of readings since.
One potential conclusion is that the U.S. equity market is more independent, so that volatility in EM equity is no longer of great concern. Does the VIX still serve as a global systemic risk indicator?
But perhaps we are asking the wrong question. An errant correlation can always be found somewhere, then shoehorned into justifying a new era of market dynamics. Perhaps current low VIX levels are accurately reflecting a globalized and coordinated risk-on environment. After all, it is not difficult to find reasons to be cheerful. The extent of ‘tapering’ has arguably been largely discounted; a surprising Fed announcement would be highly uncharacteristic. The world’s advanced economies are recording concerted positive growth; the likelihood of a fully-fledged combat operation by NATO allies in Syria is receding at considerable pace. A Greek bailout, while politically awkward, is highly unlikely to shock a well-informed market. Even the much-battered rupee is showing signs of stabilization.
Such arguments provide little reason to demote the VIX Index from its privileged position as the primary indicator of global greed and fear. If the relative independence of EM and U.S. equities has indeed increased, it has done so because of a reduction in the perceived importance of systemic risk factors (in which case a “low” VIX is arguably justfied). And if systematic global risk should increase, the unparalleled systemic importance of the U.S. equity market will mean that the VIX is uniquely positioned to reflect the evolving impact of such risks.