Russ discusses why the real economy and financial market conditions offer more clues about volatility than political noise.
During the first four days of 2018, U.S. stocks rose 2.50% and the VIX Index, a measure of implied volatility, never closed above 10, very low by historical standards. For years, investors interpreted extreme low volatility readings as a warning sign; lately it has become the norm (see the accompanying chart). Whether this can continue depends less on external culprits such as the din out of Washington and more on the real economy and financial market conditions.
Back in August, I suggested that investors should tune out much of the sound and fury emanating from Washington. While financial markets are not immune to political strife, they have historically been more resilient than many imagine. Instead, what matters is whether political uncertainty translates into economic disruption. Thus far that has not happened, suggesting that the low volatility regime can continue.
Starting with the real economy, two things have historically impacted market volatility: the level and volatility of growth. Not surprisingly, sharp decelerations in growth or recessions are accompanied by more volatility. Today, neither appear likely.
Beyond the level of growth, the variation in growth also matters. Market volatility tends to be low when economic growth is steady. During the past 20 years, economic volatility, measured by my preferred measure, the Chicago Fed National Activity Index (CFNAI), explained 20% of the variation in the VIX Index. Today’s steady economy helps explain why financial market volatility has remained muted.
Beyond the real economy, the other big driver of market volatility is financial market conditions. Cheap and available money, evidenced by tight credit spreads, explains more than 50% of the variation in equity market volatility. Recently spreads have been declining from already low levels. Since last discussing volatility in August, high yield spreads have narrowed by another 35 basis points (bps, or .35% points). This is the other reason why a sub-10 VIX has become so commonplace.