The CIO’s Take:
Well-known fear gauge on the rise
Throughout the first half of 2024 there’s been plenty of uncertainty around Fed policy, elections happening around the world, and geopolitical tensions in Europe and the Middle East—you name it. But what we haven’t seen nearly as much of is the typical manifestation of that uncertainty in financial markets: volatility. In recent weeks, though, that looks like it could be changing. Last Wednesday, the CBOE’s option-implied measure of market turbulence, the so-called ‘VIX’ spiked by 3.3 points, its biggest daily jump since March 2023. In the last two weeks, the VIX is 32% higher.
Volatility low relative to past levels
Of course, it’s all relative, and things look different if one compares these recent moves with a longer history for the VIX. Even though investors’ perceived stress is way up over the past couple weeks, it’s still low historically. Indeed, when plotted against over two decades of readings on the VIX (see below), it’s clear the recent flashes of volatility are still way below levels seen in past episodes of increased market choppiness.
Indeed, one might have imagined a narrowly failed assassination attempt on a former US president during a campaign rally—one of the events precipitating this recent bout of volatility—putting markets a bit more on edge. Back in April, a combination of fears over escalating Middle East conflict and interest rate uncertainty caused a slightly bigger spike in the VIX, but even that mini-peak to around 19.2 was short of its long-run historical average of 19.5.
Technical factors to blame?
Experts have pointed to a number of things that might be artificially suppressing the VIX, which is based on the prices of publicly traded stock options. The increased popularity of zero days to expiry (‘0DTE’) options by speculative traders seeking outsized leverage, for example, might have sapped volume away from the one-month options on which the VIX is based. A recent paper by researchers at the Bank of International Settlements suggested it’s actually demand for covered call writing strategies, the hedging of which mechanically dampens volatility.
Anxieties around Q2 earnings
Regardless of what might be leading the VIX toward a lower average against a fraught macro and geopolitical backdrop, when it jerks higher as it has in recent weeks, investors ought to take notice. One source of turbulence that we’re closely watching is larger-than-usual moves in individual stocks’ prices after reporting quarterly results. We commented last week on extraordinarily high expectations this earnings season, and some notable releases have led to big declines: Tesla’s Tuesday miss, for example, or Alphabet’s Q2 beat paired, unfortunately, with disappointing guidance.
Vol create tactical opportunities
We’ve added some risk in our models as US economic conditions seem to bring us closer to inevitable rate cuts—maybe not in September, but hopefully by year-end—though we haven’t been shy about pointing out elevated valuations for some stocks in the face of a range of real threats: from downside surprises on the macro front to continued geopolitical instability likely to be exacerbated in an election year. For tactical investors seeking to put capital to work, trends in volatility suggest to us there may be some interesting opportunities ahead.
Politics helping boost the VIX?
In our remarks above, we made more than one mention of politics, and there’s been no lack of uncertainty in the political domain since late June. After President Biden’s terrible performance in a late-June debate against then-opponent and former President Donald Trump, we spent some time discussing what a second Trump term might look like for investors. A lot’s happened since then, and it’s especially interesting to discuss in the context of the VIX. Below, we share some interesting research from Bank of America, directly connecting volatility to US presidential elections.
Researchers on BofA’s equity quant team calculated monthly average volatility over the last 24 election cycles and looked at how market stress fared over the typical timeline entering a race’s home stretch. It turns out volatility historically increases from July to November in an election year, falling back down to earth in December after polling uncertainty shakes out and the path forward is clearer. If that pattern holds, we might expect the VIX to trend up over the next few months on our way to the polls later this year.
Harris’ ascension doesn’t surprise us
As for the so-called ‘Trump trade’, some aspects of which we discussed a few weeks back, how have things changed in the days since our last election-related dispatch? When we last wrote on the topic back on July 8th, we couldn’t have imagined there would be an attempt on the former president’s life—though we might have expected his lead over Biden improving in the wake of the failed assassination. Our commentary did tip Biden’s likely exit from the race and his replacement by current VP Kamala Harris, who seems to have more or less locked up the nomination.
Trump still the one to beat in November
Judging by prediction market probabilities, Harris has marginally improved the Dems’ chances of winning in November, though Trump is still a favorite for re-election. As of last Friday, the GOP was pegged at over 54% probability to take back the White House. In this sense, things we thought might happen in the case of a Trump victory, like a steeper yield curve, a weaker dollar, and outperformance of stocks sensitive to regulation—think health care and financials—become just a shade less likely. One thing we imagine becomes more likely: that increase in volatility we just described.
Candidates likely to keep traders on edge
Markets got a taste of that policy-induced volatility just about two weeks ago when Trump opined to Bloomberg Businessweek that he blamed Taiwanese chip manufacturers for decimating America’s semiconductor industry and suggested Taiwan should be paying the US for military protection. Along with concern over bans on the sale of semiconductors and chipmaking equipment to China, such news was enough to send the S&P Global Semiconductor Index sliding by over 9% that week. We don’t expect that to be the last time US candidates will roil markets in coming months.
GDP surprises to the upside in Q2
Last Thursday morning, data from the US Commerce Department showed the US economy defying skeptics in the second quarter, growing at an annualized rate of 2.8%, marking its second full year of expansion since the last negative quarterly reading at the halfway point in 2022. Growth in Q2 was significantly higher than a consensus forecast of 2% expansion, and double the 1.4% figure reported in Q1. And where was the action last quarter? Over half of the growth in GDP came from consumer spending, with another big chunk attributable to rising inventories (see below).
PCE inflation continues downward trend
Growth is half of the story, the other is inflation—and Friday brought more data on the latter, with the Bureau of Economic Analysis releasing its Personal Consumption Expenditure (PCE) price index, the Fed’s favorite measure of inflation. Headline PCE was spot-on analysts’ expectations in June, hitting 2.5% year-over-year, a slight decline from 2.6% in the prior month. Core PCE tallied 2.6% year-over-year, also in line with forecasts. Spending rose 0.3% month-over-month, as expected, while personal income’s 0.2% increase was slightly below the consensus forecast of 0.4%.
Less fear over stagflation, corporate profits
Taken together, data on GDP and PCE certainly quell investors’ gravest concerns that we might be entering a period of stagflation. With growth as strong as it is and inflation—though still higher than anyone would like—giving up its first-quarter appearances of a resurgence, the Fed will be feeling much better going into its July meeting about the prospect for a soft landing. Seeing strong growth in Q2 should also calm investors’ nerves over corporate profits, where we’ve already highlighted the anxiety headed into the heart of earnings season.
September cut still not guaranteed
Some of the most dovish pundits we read speculated such ‘goldilocks’ conditions could induce the Fed to surprise with a July cut. In our view, that’s pretty much out of the question—though, as with much of the data we’ve seen since the end of Q1, the case for a September cut continues improving. Our base case is still for a single cut in December, with the possibility of no easing until 2025. That’s because signs the US economy continues going strong give the Fed more time to watch for the most definitive evidence inflation will soften steadily toward the 2% target.
Despite good Q2, economy likely cooling
At the same time, it’s important to remember that second-quarter GDP is backward-looking: more of a confirmation that the last three months were solid than a prediction that the rest of the year will witness the same robust conditions. We’ve had mounting indications of economic cooling, from changes in consumers’ balance sheets to loosening in the labor market, and that gives the Fed more to consider. The longer Powell and his colleagues delay cuts, the greater the likelihood they fall behind the curve and the trend in the plot above takes an unfavorable turn.
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