Submitted by Nick Colas of DataTrek Research
We will confess to some real trepidation as we say goodbye to July and hello to August. So much so that we’re pulling forward our usual month-ahead review to get several topics in front of you.
Here’s the problem: August has shifted from its traditional period of rest and relaxation to one where US equity market volatility tends to peak for the year.
Consider the following data points, all post-2010:
- In 2011, the CBOE VIX Index peaked for the year on August 8th, with a close at 48.0.
- In 2015, the VIX peaked for the year on August 24th, at 40.7.
- In 2017, the VIX peaked for the year on August 10th, at 16.0.
The closing high in the VIX for 2018-to-date was 37.3 on February 5th, the result of a meltdown in a volatility-related inverse VIX ETF. Even with today’s Facebook-driven tech wreck, the VIX is only at 12.1. Any pop in that measure that exceeds the February highs would be a real shock. Also worth noting: February has only seen an annual high on the VIX once since 1990, in 2016 (at 28.1).
Why has August become so much more volatile? Prior to 2010, it only saw the annual highs for the VIX twice back to 1990 (which is mathematically pretty close to what one would expect if volatility were evenly distributed throughout the year). A few ideas on the reasons for this shift:
- Trading volumes have been in decline since 2010, and August is typically a low water mark here within a given year. Combine these two factors and perhaps they create a notably less liquid US equity market in August where headline risk takes an unusual toll on stock prices.
- Some countries (China, for example) don’t take an August holiday the way western ones do. In an ever more global economy, market-moving news flow can come any time. Including in August.
- US equity market structure has changed substantially in the last decade. It is more automated and has less human intervention than in the 1990s – early/mid 2000s. Layer that fact on to the early points, and perhaps August is predestined to show more price volatility from now on.
What could cause a pickup in volatility in August 2018? First of all, a move in the VIX to +37 (new 2018 high territory) is not likely to come from just one event/headline unless it is something large, unexpected, and geopolitical in nature. Those risks are easy to list but impossible to predict with any precision.
Therefore, a useful catalog of catalysts works as an ensemble package; get enough of them in play, and outsized volatility will be the result. Here are our ideas on this count:
#1. Trade/tariff disputes. US equity markets have thus far taken trade negotiations in their stride, which is more than you can say for the rest of the world. The S&P 500 is up 6.1% on a price basis in 2018; the MSCI All-World ex-US Index is lower by 3.0%.
The Teflon coating around US equities is due to one thing: the market’s belief that the American economy is in far better shape than any other region to withstand the uncertainties of global trade tensions. Q2’s stellar economic and corporate earnings performances both support that idea. But to keep animal spirits fed and watered will require similar strength in the second half.
#2. Interest rates. The unsung hero in US equity markets YTD is the persistently low yield on 10-Year Treasury notes, which never really held above 3% despite much chatter on this point earlier in 2018. Higher 2-Year yields, now 2.69% and up from 1.89% at the end of 2017, haven’t mattered one bit despite offering a notional alternative to stocks.
Going into August, the market’s narrative on where 10-Year yields should be could well change. Inflation expectations (based on TIPS yields) have been remarkably constant over the last 6 months at 2.05 – 2.18% and centered on 2.1%. If US economic growth remains robust in Q3/Q4, inflation expectations will have to rise. And with that, 10-Year yields that consistently begin with a “3” rather than a “2”.
#3. Fed policy. “Inflation is a little bit below target, and it’s kind of a mystery.” That was now-Fed Chair Powell at last year’s Jackson Hole meeting. He cited low inflation as a reason to remain patient on rate increases.
This year’s Jackson Hole conference will come right at the end of August, but markets are already dialing in an expected hawkish tone for all the pre-meeting commentary:
- Fed Funds Futures give 63% odds the Fed will move twice more in 2018.
- The December 2019 Fed Funds Futures contracts made a new low just today, and now expect the central bank to raise rates at least twice more in 2019 and possibly three times (25 bp apiece).
Add all three ingredients together – more trade war concerns, higher rates and an ever-more aggressive Fed – and you get the makings of a wild August ride. In principle, they should work to offset each other (rising trade tensions create worries about a slowing economy pushing rates lower, for example). In practice, things don’t always work that way (i.e. higher tariffs mean more inflation and higher rates).
We’ll sum up where we started: August has become an oddly choppy month, and forewarned is forearmed. Absent the clear historical data, we wouldn’t even be bothering to scare the horses with our scenario analysis today. But the seasonal patterns are clear enough, so better to prepare for the worst than just hope for the best