Market Volatility Spike – Doctor, Is It Serious?
For the past 2 weeks, the financial markets have been feeling the effects of COVID-19. Are they really ill?
Lee Atwater, advisor to Ronald Reagan in the 1980s, said, "perception is reality." This principle seems to apply not only to the electorate, but also to financial markets. On paper, the health crisis linked to Covid-19 should claim fewer victims worldwide than the flu. The production of a vaccine in the next 12 months could be probable. However, the reaction of the markets has been violent, with stock markets falling by more than 20% and a peak in volatility comparable to that of the subprime crisis in 2008.
The measures taken by various countries in order to stem the spread of the virus will have real consequences for the economy, particularly in the service sector, which is very important in developed countries. The purchase of goods can be delayed, but not services – once the crisis is over, I will buy the smartphone which was out of stock, but I will not make up for all the missed visits to the restaurant or cinema.
Market reaction, however, seems disproportionate and reflects an aversion to risk and uncertainty. 2019 was an excellent year for investment. Even though the current financial situation in Europe is more severe, Swiss and US equity indices have, over the past couple of weeks, lost only their 12-month gains and not the 10-year profits, as was the case in 2008. In reality, investors which bought equities 5 or more years ago, are still sitting on a comfortable capital gain. Nevertheless, various authorities (Governments, Central Banks) have resolved to take measures to support the economy.
Even if, during this difficult period, these measures are necessary in order to provide a safety net for small and medium-sized businesses that do not have easy access to financing, they will not be enough to calm the fears of the population at large. Are we going to stop staying at home just because the Fed is increasing its balance sheet?
In reality, the precautionary principle applies not only to health policies, but also to those of Central Banks. Unfortunately, for too long now Central Banks have had a blank check to support the stock market at all costs. After years of unjustified intervention, they find themselves facing a serious crisis, where they are having to treat a patient who has developed a strong resistance to their therapy, but where they find themselves with not many solutions in their medicine chest.
If Central Banks cannot support prices, where can they turn to protect their portfolios. It is clear that it is always the same assets that prove to be effective: the Swiss Franc, Gold, US Government Bonds. While these traditional defensive asset classes have risen by a few percent, the VIX index tripled in 2 weeks. As in previous crises, volatility has demonstrated its effectiveness as a protection, not only because it is negatively correlated with equities, but also because it is able to react explosively in the event of a stock market correction and it has no upside limit.
Volatility is also an effective thermometer for measuring the nervousness of investors. Two facts are worth noting – the rise in implied volatility, deducted from the price of options, was less strong and less rapid than that of realized volatility, calculated on the basis of actual market movements. This indicates that investors did not need to rush to buy volatility or to cover short volatility positions, as was the case in February 2018. Furthermore, medium-term volatility also increased sharply, a sign that investors expect the market to remain volatile for many more months to come.
It is still too early to draw any conclusions from the Covid-19 crisis. Some claim that it will lead to an awareness of the fragility of our way of life and to curb globalization. For the investment world, particularly that of quantitative strategies, it constitutes a real life stress test, the results of which will only be apparent once the markets have stabilized. What will be the state of the balance sheets of the Central Banks and Government budgets at the end of the crisis? Can artificial intelligence and algorithmic investment strategies take into account the fear of a virus? Does a volatility-based risk equalization strategy still make sense when volatility explodes further? The answers to these questions will be fascinating and will force investment professionals to update their methodologies.