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Written by: Scott Colyer | Advisor Asset Management
Last week we experienced an abrupt, and somewhat unexpected, mega-spike in the CBOE Volatility Index (VIX). The VIX is a widely followed measure of equity market volatility and is often considered a gauge of fear in the markets. Last week, the VIX spiked to 65.73 — spikes above 60 are relatively rare, historically. Following such a spike in volatility, it’s common to experience aftershocks, just like with earthquakes, and the damage can continue.
Since the turn of the century, we have witnessed just three spikes in the VIX to more than 60:
- 2008: At the peak of the market meltdown surrounding the Global Financial Crises.
- 2020: At the beginning of COVID.
- 2024: In August, preliminarily blamed on an unwind of the Japanese Yen “carry trade.”
To expand on 2024’s spike, there was a massive, short position in Japanese Government bonds (denominated in yen currency). The proceeds from the short positions were invested in growth trades, including tech stocks during the past couple of years. These stocks are denominated largely in U.S. dollars. The idea is to use the funds from the short sale of Japanese bonds (costing less than roughly 0.25% per year) and invest in higher-yielding assets elsewhere in the world. The hidden risk in this trade is currency risk. There is the risk of being short yen-denominated securities and long dollar-denominated securities. A perfect storm hit over the past few weeks when the yen began to strengthen against the dollar and simultaneously tech stocks began to sell off. The culmination of the risk was capped when the Bank of Japan raised the borrowing rate, which caused a tumultuous selloff in Japanese stocks (12% in one day). To unwind the trade, investors had to sell their dollar-based tech stocks and buy back their short position in Japanese bonds. The currency moves, as well as the selloff in U.S. tech stocks, caused the trade to begin losing money at an alarming rate.
It is not unusual for pain to be had when the crowd runs for the door. Many believe that unwinding this “carry trade” is either done or very close to it. However, history shows us that it is very likely that volatility will persist well after the initial spike. Periods of increased volatility are often paired with underperformance in equity markets. The chart below shows this correlation over the past 30 years given spikes in volatility.
Source: BofA Global Research. Past performance does not guarantee future results.
It doesn’t help that we are seeing the U.S. economy begin to slow down, with some questioning the reality of a “soft landing.” Remember, the Federal Reserve (Fed) has only achieved one soft landing since WW2. The Fed has continued to indicate that they are monitoring the data and will begin to cut rates soon. History tells us that the Fed generally waits too long to ease and many times they must react quickly when something in the economy breaks.
We are seeing the yield curve inversion dissipate and it appears that it may be steepening into a positive (normal) slope. This steepening often corresponds to the beginning of an economic recession. The next graphic shows the relationship between the U.S. Treasury yield curve going from inversion to positive pitch and when past recessions occurred. Will this cycle happen this time? It is hard to tell because so many of the economic “markers” that precede recessions haven’t been reliable so far in this business cycle.
Source: BofA Global Research
We don’t think the economy is breaking, but we believe that the spike in the VIX is something to be respected and that investors’ asset allocations should be ready for the aftershocks. For us, we believe that lower, short-term rates will benefit some of the most depressed parts of the equity markets including real estate investment trusts (REITs), financials, healthcare and utilities. Consumer staples are close to their valuation lows and consumer discretionary are close to their highs. Staples tend to be defensive and could outperform discretionary on a relative basis if a slowdown gains speed. Finally, high-grade bonds tend to do well when rates are cut.
Regardless of the economy over the next 12 months, we think it is time to shift from offense to a more neutral risk stance of quality and defense.
We don’t see a recession on the horizon, but we see conditions that could lead to one.
In the asset allocation business, risk happens fast. We don’t see a protracted bear market, but we would like to have some cash on hand to do some buying when the aftershocks happen.
Related: Validating Market Theses: The Significance of Tracking Money Flows