Falling VIX doesn’t have to herald a correction in US equities - Capital Economics
Capital Daily

Falling VIX doesn’t have to herald a correction in US equities

Capital Daily
Written by John Higgins

There may be growing concerns that a correction in the S&P 500 lies around the corner, because the expected volatility of the index has fallen to a pre-pandemic low. This would presumably be because low levels of expected volatility have sometimes been followed by major drawdowns in US equities.

  • Energy price effects may have boosted inflation in China, Brazil and Sweden last month
  • We think that Germany’s industrial production rose strongly in April (07.00 BST)
  • Canada’s employment probably grew in March, but is unlikely to do so this month (13.30 BST)

Key Market Themes

There may be growing concerns that a correction in the S&P 500 lies around the corner, because the expected volatility of the index has fallen to a pre-pandemic low. This would presumably be because low levels of expected volatility have sometimes been followed by major drawdowns in US equities.

Our view, though, is that these are not caused by low volatility, but by the sort of unanticipated, unwelcome developments that we are not factoring in our forecast for the US stock market. (See here.) On the contrary, we think that the S&P 500 will remain underpinned this year by a strong economic recovery aided by very accommodative monetary and fiscal policy.

To-recap, the VIX index – a measure of the expected volatility of the S&P 500 – has fallen towards 17 this month, its lowest level since the onset of the COVID-19 crisis. This has coincided with the S&P 500 breaking above 4,000 for the first time ever.

While the recent decline in the VIX index might convey the impression that investors are becoming too complacent, it is perhaps surprising that it hasn’t fallen more quickly and to an even lower level. After all, expected volatility tends to be informed by the volatility investors have observed in the past. And the 30-day volatility of the S&P 500 had already dropped to near a pre-pandemic low earlier this year. (See Chart 1.)

Chart 1: Volatility Of S&P 500 (Annualised, %)

Sources: Refinitiv, CE

The VIX index, by contrast, remains even now significantly higher than it was before the crisis took hold. This may be partly due to very strong demand for call options on individual equities, which has driven the overall put/call ratio for them down sharply. (See Chart 2.)

Chart 2: CBOE Individual Equity Options (90-Day Avgs.)

Source: Refinitiv

Of course, the strength of demand for call options on individual equities could itself be construed as a worrying sign. But there is no evidence of a surge in demand for call options on equity indices, which might have also been expected if investors were throwing caution to the wind. (See Chart 3.) (John Higgins)

Chart 3: CBOE Equity Index Options (90-Day Avgs.)

Source: Refinitiv

Selected Data & Events

BST

Previous*

Median*

CE Forecast*

Fri 9th

Chn

Consumer Prices (Mar.)

02.30

(-0.2%)

(+3.5%)

(+4.0%)

*m/m(y/y) unless otherwise stated; p = provisional


Key Data & Events

US

The minutes from the Fed’s mid-March meeting continued the dovish tone of recent communications, and offered few hints of any serious disagreement amongst officials over how long to leave interest rates near zero. We still expect a more sustained rise in inflation to prompt the Fed to start raising rates a little sooner than FOMC participants’ latest projections imply. But with the minutes revealing that as many officials are worried about the downside risks to inflation as those worrying about a sharp rise, we suspect that first rate hike will not happen until late 2023. (Andrew Hunter)

Europe

The account of the ECB’s March meeting showed that the decision to increase asset purchases was agreed by all members, but that some were reluctant to do much more. In practice, purchases have not risen very far since then. Given that the Bank could have ramped them up much further, it seems that policymakers are broadly content with the current level of yields.

Meanwhile, we learned that Germany’s industrial orders rose in February, supporting our view that industrial production there increased by around 2% m/m in that month (data due on Friday). Elsewhere, core inflation in Norway is likely to have edged down again in March, but energy effects have probably pushed the headline rate to a record high of around 8%. And monthly GDP data from Sweden for February indicated that output is highly likely to have expanded in Q1. The recent surge in virus cases there casts a cloud on the government’s plans to ease restrictions again soon, but Sweden’s economy is still likely to regain its pre-crisis level before most other European economies. (Melanie Debono)

Other Developed Markets

We expect Canada’s Labour Force Survey to show that employment rose by a further 150,000 in March, although the renewed restrictions imposed this month may mean that some of that gain will be reversed in April. (Stephen Brown)

China

We expect data due on Friday to show that consumer price inflation rose to a five-month high last month, ending a brief spell of deflation. Base effects from the slump in oil prices a year ago probably boosted energy price inflation, while higher food prices are likely to have nudged up food inflation. We think that core inflation remained roughly stable, while base effects mean that producer price inflation probably jumped. (Sheana Yue)

Other Emerging Markets

In Latin America, Mexico’s inflation figures for March showed a jump in the headline rate to 4.7%, largely due to higher fuel inflation. The same factor is likely to have pushed Brazil’s inflation up sharply last month too, which may prompt the central bank to raise rates further. Meanwhile, Mexico’s industrial production figures for February are likely to show a fall of around 2% m/m, as the sector was hit by energy problems in that month. Finally, we think that Peru’s central bank will leave its policy rate at 0.25% at the conclusion of its scheduled policy meeting later on Thursday.

In Sub-Saharan Africa, activity data from South Africa showed that manufacturing production contracted by 2.1% y/y in February. We suspect that the sector’s recovery will remain sluggish as a slow vaccine roll-out, persistent power cuts and fiscal austerity will continue to weigh on domestic demand. (William Jackson & Virág Fórizs)


Published at 17.10 BST 8h April 2021.

Editor: John Higgins, john.higgins@capitaleconomics.com

Enquiries: Jack France, jack.france@capitaleconomics.com