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Volatility is Back

By March 27, 2018 No Comments

It’s back! Volatility has returned to the financial markets.

The year got off to a calm start, but the stock market saw a return to larger daily price moves. Such volatility has many investors moving more funds to bonds or cash. Sounds reasonable! But economic conditions still favor stocks.

The primary way to measure risk, or uncertainty, in stocks and other financial instruments is to look at option contracts. These risk measurements are generally spoken of on Wall Street as Fear Indices.

The most famous is called the VIX.   The CBOE Market Volatility (VIX) is an index of stock option trading for the large, US-based companies in the Standard and Poor’s 500 Index. The VIX index reflects the cost of hedging risk through the sale or purchase of option contracts on the stocks of US companies. Option prices rise when the underlying stock prices move dramatically in one direction or another – reflecting greater uncertainty over what the price will be in the future.

As of the middle of March, The Chicago Board Options Exchange’s VIX index is at 17 percent, compared to an average daily rate of only 11 percent for all of 2017.  Statistically, this is a big difference. A 6 point rise reflects a large rise in expected risk.

The 17 percent value of the VIX index is a statistical measure called standard deviation. The VIX is saying over the foreseeable future we can expect to see stock returns deviate from their long run average by approximately 17 percent on an annualized basis. In terms of probability, a 17 percent deviation means there is about a 1-in-4 chance investors will be down over the course of the next year.

Therefore, stocks look more risky this year than last. But this rise in uncertainty comes at a time when things look very good in the real economy.

The three main indicators of our macro economy – income, prices, and employment – are all showing improvement. The nation’s income, or real gross domestic product (real GDP), is growing at a 2.5 percent annual rate based on the most recent report. This compares to only 1.5 percent growth in 2016.

According to the Congressional Budget Office (CBO), the US economy is now operating at its potential, meaning we are using all our workers and all our capital equipment fully. In theory, this means prices of goods and services should be rising more quickly.

The inflation rate, however, remains below long-run averages. As measured by the Consumer Price Index (CPI) index, inflation today is 2.3 percent, compared to an annual average of 3.3 percent since the 1980s.

Meanwhile, the labor market is strong. The national unemployment rate stands at only 4.1 percent, below the 4.7 percent rate which the CBO estimates to be normal.

If the economy is doing well why should stock prices be any more volatile? What’s the risk?

The financial market uncertainty seems to center on the fiscal and monetary policy of governments around the world.  What policies are changing that will hurt corporate profits and stock prices?

In terms of fiscal policy, most developed nations continue deficit spending, raising government debt levels. For monetary policy, central banks continue to hold bank interest rates below historical averages.

The US public debt situation is unchanged with total federal debt holding at just over 100 percent of GDP.  The debt levels of other major governments are growing even more (e.g., Japan).

Central banks around the world continue to support such government borrowing with relatively easy monetary policies, or liquidity in the banking system. High bank liquidity keeps interest rates below market equilibriums and creates uncertainty over the consequences of how fast central banks may raise rates.

Fortunately, classical economic theory and historical evidence show us that these two situations should not concern us. First, economist David Ricardo (1772 – 1823) showed when people expect taxes to be raised to offset the future payments of principal and interest on current debt, then today’s debt financing is equivalent to a tax.

That means there is no real difference if the government taxes its citizens or borrows to finance its spending. Thus, rising government debt levels shouldn’t affect corporate profits any more than current taxes. Companies have made good money even when governments run deficits.

Second, economist and philosopher David Hume (1711 – 1776) showed monetary policy has no real effect on the economy. Monetary neutrality is the theory that over time changes in the level of bank money and credit affects only nominal variables, such as interest rates and exchange rates. Such changes have no effect, however, on real variables like income and consumption.

Therefore, banks and other financial institutions may be at risk as interest rates rise, but most companies will see no harm. Households will even benefit from better returns on their savings.

With interest rates still below normal and the underlying economy humming along, stocks remain the better value over bonds or cash despite rising uncertainty. The near-term outlook for increasing household incomes and corporate profits remains strong.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

 

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

 

[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

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