Weekly Update

The Impact of Falling Volatility


Published July 28, 2023

Below is the latest from Blake Millard’s “Sandbox” blog. We hope you find it interesting.

Quote of the day

“I always say that while we can’t know where we’re going, we ought to know where we are (in cyclical terms). Understanding our environment can help us decide what tactics to employ, how aggressive to be, and which potential mistakes we should try hardest to avoid. Being conscious of cycles can be extremely helpful, even if we can’t see the future.”

– Howard Marks, It’s All Good

VIX the key to unlocking markets?

The CBOE Market Volatility Index, or VIX, has been volleying back and forth in a narrow range of 12 to 15 since June. Let’s unpack how we got to these levels.

The inflation narrative dominated headlines in 2022, peaking sometime around October. And when inflation “hit a wall” in October, so did equity volatility. This is around the same time when the U.S. dollar peaked and interest rates stopped backing up.

3-year look at VIX

Refreshing our memory banks a little bit, October 13th is when we received another jumbo +0.6% MoM core inflation reading, causing the S&P 500 to gap down pre-market over -2% to only end the day positive (+2.6%, in fact) on the back of a fierce intra-day rally. This marked the stock bottom. Ever since, the collapse in VIX has been impressive, especially when weighed against the incredibly uncertain macro backdrop and tightening of financial conditions.

And falling volatility is generally a good thing for asset prices. In fact, after a negative return year (like 2022), the median equity gain the next year is +22% (win ratio 83%, n=23) when the VIX falls, versus equity losses with a median -23% return (win ratio 14%, n=7) when the VIX continues rising.

Post-neg year, impact of cross-market variables

As the scatter plot below highlights, we can see the sizable influence of the VIX. Even in “All Years,” the bifurcation in outcomes shows VIX is a key differentiating input in realized returns.

Strong performance when VIX falls

So, is 2023 all just a volatility narrative?

Source: FS Insight

S&P 500 performance following the end of Fed hiking cycles

Yesterday, the Federal Open Markets Committee (FOMC) raised its target interest rate to 5.25-5.50%. Despite Fed Chair Jerome Powell stating the upcoming meetings will be “live” – meaning decisions will be made real time based on the incoming data – many believe the Federal Reserve is done hiking interest rates this cycle.

In recent market history, U.S. equities have generally rallied in the months following the end of past Fed tightening cycles.

S&P 500 performance around the end of Fed hiking cycles

In the 3-months following the peak Fed Funds Rate, the S&P 500 has returned an average of +8%, ranging from +14% to -1% and rising in 5 of 6 episodes. On a 12-month basis, the S&P 500 has returned an average of 19%, rising in 5 of 6 episodes and rallying by more than 10% in each of those.

Comparing the current hiking cycle to 6 previous cycles since 1982

At the sector level, returns at the end of hiking cycles have been inconsistent. No sector out- or under-performed in every episode. Financials have outperformed the S&P 500 most consistently, leading the market in 5 of 6 cycles; Materials posted the worst hit rate (17%).

S&P 500 sector performance following last Fed hike

The big question is how much of the market has already priced this in.

Source: Goldman Sachs Global Investment Research

U.S. economic growth re-accelerating

The recession that everyone and their mother was expecting in 2023 must wait another day.

U.S. GDP growth accelerated to a 2.4% annualized rate in the 2nd quarter, above consensus expectations and the prior quarter’s growth of 2.0%. Economic activity seems to be striking the delicate balance policymakers want to see: strong, but moderating, activity.

U.S. economic growth accelerates

Today’s report was led by private non-residential fixed investment, or “CapEx” – think spending on buildings, equipment, software, etc. It jumped at a 7.7% annualized rate, contributing 0.99 percentage points to the top-line number.

The re-acceleration of growth is a testament to the underlying strength and resilience of the U.S. economy since it comes on the heels of more than a year of Fed tightening which brought the Fed Funds Rate to its highest level since 2001.

Soft landing?

Source: Dwyer Strategy, Ned Davis Research, Bloomberg

Competing credit narratives

One story on credit says credit spreads (3.9%) on U.S. high-yield bonds are the lowest since April 2022 and well below the 10-year average of 4.5%.

U.S. high yield master II option-adjusted spread

The other story, when looking at a broad range of indicators – rising delinquency rates for credit cards and auto loans (see chart below), rising default rates for HY and loans, rising corporate bankruptcies, slowing loan growth for banks), says the lagged effects of Fed hikes are finally creating fractures in credit.

New seriously delinquent (+90 days) balances by loan type, % of current balance

With a higher cost of capital, this story is still in its first act. More to come…

Source: Apollo Global Management


Market Update

A big week in stocks as the Fed’s most recent interest rate decision loomed while a huge slate of corporate earnings were reported. Monday brought a modestly positive +0.4% gain in stocks with earnings from Chevron and Halliburton pushing energy shares higher. A blowout weekend at the cinema houses offered encouragement about the state of consumer spending. Tuesday added +0.3% to market indexes on positive earnings from GE, Dow Chemical, and 3M. The trio of industrial winners pushed the Dow Industrial Average to its 12th consecutive gain. A solid report from Boeing continued the Dow’s winning streak Wednesday while investors took the Fed’s long-expected interest rate hike in stride. Reactions to big tech earnings were mixed with Microsoft slipping on its report while Alphabet/Google rose solidly. Homebuilder Pulte also pleased investors as home construction picks up steam. Stocks endured a big negative reversal Thursday with interest rates spiking. Second quarter GDP came in at 2.4%, higher than expected, while earnings from Meta (formerly Facebook), McDonalds, and cruise liners all were warmly received. Maybe the higher GDP print pushed the narrative of higher-for-longer interest rates? Or maybe investors decided to take profits for the day after the Dow’s historic 13 session win streak. Whatever the cause, stock indexes gave up a hefty +1-2% open to close lower by -0.5%. But the selloff looked like a one day event as Friday brought buyers into the market dip. Another report came in Friday showing sharply falling inflation while better results from semiconductor maker Intel boosted shares in that key sector. The reports eased concerns evident in Thursday’s market to send the S&P 500 back upward recouping much of Thursday’s swoon.

A volatile last couple of days failed to keep the S&P 500 (SPY) from closing the week higher by +1.05%. The Nasdaq 100 (QQQ) closed up +2.09% to its highest weekly close since the end of 2021. The index has almost completely recovered the ground lost in the 2022 bear market. Not so for smallcap stocks (IWM), which remain nearly -20% below previous highs. The index found a +1.01% gain this week though.

Warm wishes and until next week.