While we grow weary of endless talking-heads pointing to contemporaneous VIX charts as somehow indicative of why equities are up/down/sideways and the lack of comprehension of the non-directional bias of what is simply a measure of dispersion, we do recognize the critical way that volatility-spikes (and other vol-related indicator divergences) reflect short- and medium-term market uncertainty. Having modeled business cycles through the eyes of realized and implied volatility, we were heartened to read Goldman Sachs excellent discussion of the macro-economic impact of uncertainty shocks and why the post-2009 vol spikes leave global growth at much greater risk of significant downside. Critically, they note that while previous episodes of vol-spikes have been relatively well-contained, current risks seem much less tightly defined with unusually frequent bouts of extreme volatility, leading to much longer-lasting impacts on growth than normal.
Goldman Sachs Global Economics Weekly
The Risks to Global Growth from Spiking Volatility
One of the most striking complaints from investors and businesses over the past few months has been that uncertainty about the future economic outlook is so much higher than normal, making it harder to commit to decisions to spend, hire or invest. Uncertainty about the Eurozone sovereign crisis, the US debt debate, the fiscal hangover from the crisis, the regulatory response and the efficacy of counter-cyclical policies are all frequently cited issues that cloud the outlook.
In financial markets, the sharp rise in market volatility - unusual this far into a recovery - reflects the same phenomenon. Over the past few months, the VIX - the most widely followed measure of implied equity volatility - spiked to 48 and realised equity volatility rose above 40. The messiness of the US debt ceiling debate and the intensification of the Eurozone crisis over the summer were the proximate causes, but concerns about a renewed recession against the background of constrained policy have loomed large.
It seems natural that this kind of spike in uncertainty and volatility not only reflects economic worries but will itself have an impact on the growth picture. Economists since Keynes at least have understood that rising uncertainty and volatility are likely to hurt spending, particularly for big-ticket items like durables and investment purchases.
They go on to discuss why uncertainty matters - explaining how the 'option' for CEOs to 'wait-and-see' on spending decisions becomes so much more valuable when volatility is high (just as puts and calls are more 'valuable' when implied vol is high):
The [most recent] shocks associated with the shift in financial markets were the renewed pressures as the Eurozone financial crisis spread in earnest to Italy, and the loss of confidence that followed the US debt ceiling debate and downgrade. But on a range of issues, the world has seemed a more ‘binary’ place of late. Implied volatility in equities is one of the cleanest proxies for financial market views of how uncertain the future might be.
While the renewed volatility in markets is a reflection of these economic forces, most investors’ intuition is that this uncertainty is in turn a weight on the economy itself, and one that may dampen activity going forward. It is common to hear that CEOs are less comfortable committing either to invest or to hire until the situation in Europe, the path of the US economy or the regulatory picture becomes clearer.
This intuition has long been a part of how economists think about spending decisions, particularly large irreversible decisions such as investments or durable purchases. By committing to a big purchase, you relinquish the ‘option’ to wait for more information about whether it is a sensible idea or not. When uncertainty is high, that option is particularly valuable. And so it may make sense to delay decisions until things become clearer, entering a ‘wait-and-see’ mode in the meantime.
Of course, all of this is irrelevant without a framework for judging vol impacts and using complex-sounding (but actually rather straightforward) VAR modeling, Goldman is able to create an impulse response function - simply put, given a spike in vol, what happens to various macro factors over time:
As is clear, the peak (negative) impact post a vol spike occurs around six months with a 1% drop in industrial production and a 0.6% drop in employment. This is 'averaged' over seventeen major vol-spike scenarios that have occurred over the past 55 years. The latest spike in vol is large enough and prolonged enough to suggest the same kind of impact this time around - leaving the impact likely to peak in early 2012.
Not exactly a positive sign for all the global growth decoupling theorists, but Goldman does note four important factors when trying to translate this perspective into growth expectations:
First, one key consideration is the important qualifier above: ‘than otherwise’. Our results suggest that growth should be weaker than it would have been, but the baseline still matters. Most of the US data - as summarised by our CAI - has not yet shown further deceleration since the summer. The volatility shock is really only two months old, so much of the data needed to assess its impact may not yet be available. But our analysis - and Bloom’s - suggests its impact should be being felt by now. If it continues not to be visible in absolute terms, this would suggest either that we are seeing a lower impact than average or that, without it, growth would have been improving (as many forecasters believed going into the summer).
Second, we have highlighted the unusually depressed state of durable spending, the low level of inventories and the low levels of housing investment, at least for the US economy, as a reason for thinking it is harder to generate a significant recession than normal. Given these are key areas where uncertainty delays spending, the fact that they are already at low levels may dampen the impact of volatility relative to some other episodes.
Third, the uncertainty shock is not the only shock. The direct impact on financial conditions has been sizable in places, particularly in some European economies. And in the US, we still worry about the impact of fiscal restraint. These forces may ultimately play a greater role in determining the outlook than the impactof higher uncertainty and volatility.
Fourth, uncertainty shocks may not be over. What is unusual about the current recovery, as we mentioned earlier, is the recurrence of bouts of extreme market volatility. We saw one in May 2010 and again this year. Our central view is that, despite the latest policy commitments, the Eurozone sovereign crisis is unlikely to have a lasting resolution soon. And many other issues that have generated uncertainty - the US fiscal debate and the constraints on monetary policy - are unlikely to fade soon either.
From which they conclude, rather pessimistically:
... the current risks — particularly in Europe, but also more broadly — seem much less tightly defined and, as we have showed, the frequent recurrence of bouts of extreme volatility is unusual. The risk is that we are in an environment where volatility is more persistently higher than normal, at least until a broader resolution of the major policy risks is provided. Until that resolution is forthcoming, and we can be confident that volatility is receding more permanently, it will be legitimate to worry that its impact on growth could also be longer-lasting than normal.