2022 was the year that volatility made a comeback as transitory inflation proved to be anything but. FOMC Chairman Powell, finding himself increasingly behind the inflation curve, began to promise and deliver aggressive rate hikes, putting fear into equity investors. And so it went throughout the year with the market continually underestimating the pace of hikes and continually having to be reminded, receiving its routine scolding from both Powell and a supporting cast of Fed representatives. The market lurched and gyrated, and volatility soared. Then January 1 of this year came, and it was like someone flipped the proverbial switch. And volatility collapsed.
A favourite market idiom of mine comes to mind when observing markets this year: “Climbing the wall of worry.” Markets have been very good at that of late – after all, there is plenty to worry about these days, or so they say. Debt ceiling concerns, an ongoing US regional banking crisis, a tightening of financial conditions, geopolitical rumblings, and, while perhaps better than the worst expectations, an earnings recession as David Rosenberg points out. We have had historic swings in bond markets, and long-term rates have been rising once again. US credit default swaps are trading at significantly higher levels than those of Mexico and Brazil.
But judging by the moves in Wall Street’s major stock indices, the banking crisis appears to have been a nothing burger. Sure, the VIX (CBOE Volatility Index) did hit a high of almost 31 following the collapse of Silicon Valley Bank, but it fell rather steadily back to around 21 soon afterwards. Right now, it sits near 16 and well below its long-term average of around 21. Yet Treasury volatility remains curiously very high and still very much in an uptrend. It is far outpacing equity volatility, which is trending downwards. So why the very large divergence of bond and equity volatility, a ratio that sits near all-time highs?
Some of the blame lies in the structure of the equity market. Stocks like Microsoft, Apple and Alphabet carry a heavy weight in the index. A flight to safety in cash-rich, healthy balance sheet, and A.I. rootin tootin big cap tech leaders has led to a bifurcation in performance. Indeed, a vast majority of the performance in the S&P500 in 2023 comes from this handful of stocks – a chart of equal weight Index performance versus market cap performance illustrates this well. Below the surface, however, it might seem that all is not so well, with the Russell 2000 continuing to plumb the depths just as names like Nvidia and Meta enjoy meteoric runs of near 100% year-to-date.
In other words, a few stocks could be masking a troubling undercurrent. Because of their importance to the index this has translated into a veneer of calm from a volatility perspective as well. Microsoft, Nvidia and Apple sit roughly 6, 5 and 3% below all-time highs while many stocks struggle to break above some key moving averages. A few “safe haven” stocks are doing much of the heavy lifting, driving down broader index volatility as the economy begins to gasp for air as evidenced by the underwhelming broader performance from other US stocks, domestic in particular.
A recent BofA Fund Manager Survey showed a level of pessimism not seen since October 2008. I think they are seeing a deteriorating macro environment, even higher rates to come, and most importantly high rates for longer. I am seeing a broader market that is increasingly held together by a few hard-charging “safe” tech behemoths, companies that are ultimately not immune to an economic slowdown. I believe this sense of calm can be taken away as quickly as it came.
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