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The Big Conversation

Episode 126: Is there enough volatility yet?

This week Roger Hirst looks at the current level of volatility, which is high, but not excessive. Most major market lows are telegraphed by a surge in volatility, but should we expect that again this time? In fact, the volatility of volatility is remarkably well behaved. This could be due to the structural sellers who are unwinding based on rules, rather than panicking on the back of emotions. In the Chatter segment, we look at the structure of the UK’s financial services sector and the changes that are taking place in the aftermath of the murder of George Floyd.

  • Roger [00:00:00] The S&P has now fallen 20% from its highs on an intraday basis, and yet volatility is lower than it was during the initial sell off before the Ukraine war. Today, we're not seeing the sort of volatility conditions that have marked a major low in the past. But should we expect them this time? Welcome to The Big Conversation.

    Roger [00:00:23] In the world of US small businesses and household consumption, which are the lifeblood of the US economy, things have been moving very quickly. Consumer sentiment is back at the lows and remains deep in recessionary territory. The NFIB Small Business Optimism Survey has also been falling. Retail stalwarts have seen their stock prices sharply decline and this is because of the speed with which inflation has moved from almost nothing a couple of years ago to a 40 year high today. And during the last 50 years, CPI in excess of 5.3% has always peaked inside a recession. Whilst we don't know if inflation has peaked for this cycle yet, there was only the 1979 to 1980 peak in inflation where it took a few more months once CPI passed 8% before a recession was registered. Yet the stock market remains well-behaved despite the pullbacks that we've been seeing so far. And if you look through Twitter, you'll see loads of compelling arguments both for and against the usual spike in volatility that has historically indicated a major market low. Reality is probably somewhere in between. So let's have a look at some of those views. Implied volatility as measured by the VIX is high, but it's not expensive and it's certainly not at excessive levels considering the underlying market performance. Implied volatility is normally at a premium to the actual or historical volatility of the market. Effectively, the cushion that volatility sellers take in order to sell that risk. Today, however, the actual volatility of the market is the same as the VIX, meaning that the volatility whilst high, is fairly valued. And by way of example, if implied volatility, which is what you pay for an option, is at 30 and the underlying market is moving around on a volatility of 15, then implied volatility can be considered both high and expensive. If the implied volatility is 30 and the market is also moving on a 30, then volatility is considered to be fair value. Furthermore, the VIX curve today may be high, but is also very flat, which means the volatility today is very similar to the volatility for options that expire in a few months time. In most normal markets, spot volatility is much lower than future levels of volatility. But six months ago, when spot VIX was around 18, six month VIX was closer to 26, meaning that longer dated options were optically expensive. And when there is true stress in the system, however, we would expect to see spot volatility that is much higher than forward volatility, as we can see in the extreme case of 2020 compared to today. Again, this implies that volatility might be high today, but it's not showing true signs of stress. And we should also take a look at volatility of volatility - the VVIX - which is the implied cost of buying options on volatility itself, this has seen some significant spikes. But on most of these big occasions there was a var shock for short volatility funds rather than a spike on the back of a major market drawdown - the exception being 2020. There have, however, still been spikes of VVIX during normal bear markets like we had at the end of 2018, but they are not as dramatic as those other instances. Today, however, vol of vol remains close to a three year low. There's almost no stress coming out of this indicator, and this is in part due to many of the structurally short volatility players having left the market in recent years. But that still doesn't explain why it's so low today compared to the last 12 months. And part of this measured outlook to volatility is that we've been seeing measured selling from rules based funds that use volatility as an input into their asset allocation decisions. Now as we saw earlier, historical volatility has been steadily rising, and this means that many multiasset funds will have been steadily reducing their allocations to risk assets. But there has not been that sudden deleveraging, and small size investors have also still been buying single stock put options in decent size. And if these investors are taking profits into those sell offs, then they'll also be selling volatility as that market declines. It has, however, been estimated that of the 1.3 trillion of capital that's come into US stocks since the pandemic, only two out of every hundred dollars has since left.

    Roger [00:04:29] And it could be capitulation here that will push volatility higher, but that's not yet occurred. And a true bear market should still see a liquidation event. And some investors are buying call options on the VIX in anticipation of a spike higher in volatility. The VIX is that fair value. The VIX curve is flat and volatility of volatility is relatively low. And yes, there are fewer structural shorts today, but many rules based funds that make up a significant part of the market today are implicitly short volatility. Chris Cole of Artemus Capital Management has highlighted that the explicit short vol strategies that may have left the market were just the tip of the iceberg. So whilst we shouldn't necessarily be expecting a spike in vol of vol, we still haven't seen the obvious indicators of a major market low. And what people really want to see is a sudden tradable low right here, right now. But, a grindingly lower market with countertrend rallies is probably more likely than the sudden capitulations that we've been used to seeing over the last five years.

    Roger [00:05:30] Now, in this section, we've been looking at the structure of the markets. In the next section, we'll be looking at the structure of the industry and the changes that are taking place in the financial services sector within the UK in the two years since the murder of George Floyd.

    Roger [00:05:50] So two years since the murder of George Floyd and there's been a lot of it seems there's been a lot of progress in the issues around diversity. But is this in some ways a bit like the stuff with climate change and ESG, where there's been a lot of talk rather than actual actions so companies are wanting to be seen to be doing the right thing to attract an investment. But are you actually seeing companies doing the right thing, actually walking the walk as well?

    Michael [00:06:13] Great question. And I think the answer I have to give you is one context, because there are some organisations who are far more advanced when it comes to D&I and belonging than some of their competitors. So if we take our mind back in May the 26th, 2020, a number of CEOs came out with some big statements with regards to the Black Lives Matter movement and also what they want to do. And ultimately, I can say that a number of organisations have made positive first steps. So we've mentioned Sir John Parker's review, 89 of the FTSE100 companies have ethnic minorities on the board.

    Roger [00:06:55] And having those ethnic minorities on the board, is that something which is a boardroom level thing again for appearances or are you seeing it actually trickle down to the organisation as a whole?

    Michael [00:07:04] So again, yes, I think what we've seen and I've been privy to being in meetings where new appointees on the board are actually shaping the narrative of the CEO. It's about creating a safe space Roger.  And ultimately we've spoken about it being overindexed, but you look at the FTSE100, 89% of the CEOs come from a private school education, whereas only 9% of the UK population have attended private schools. Okay, so you then break it down from a diversity standpoint, how many diverse minority ethnics are going into private school education? So what we have seen is a number of the CEOs are leaning in to people on their board because, again, it's a safe environment because the overall consensus is they want to do more. But it's about culture. It's about being in the position of not making mistakes and being penalised for it.

    Roger [00:08:00] And the UK financial services industry is still in the early stages, you've seen these developments much earlier, you know, it's a legacy positions in some of the US financial companies and within those companies it's, you know, it's the sort of feeling that the diversity actually increases opportunities, not knocking people out of potential jobs it's actually that diversity increases the overall ability, the overall bottom line of some of these companies, because diversity is opportunity of trading, opportunity of revenue, opportunity of income.  And so is that driving force, you know we're actually seeing that there is an understanding within these companies that this is actually going to help the bottom line, it's a commercial interest as well as anything else.

    Michael [00:08:41] Well, if we look at emerging markets, so when you look at from an investment banking standpoint, you look it at from a trading or distribution standpoint in the UK, that is where we see black coverage bankers in emerging markets or sub-Sahara, because there's a business need. So I don't think it's been a case of organisations understanding, or a lack of understanding about the commerciality. But I think the next stage, Roger, is around education, explaining to white middle managers that this is going to provide upside and opportunities for them in their respective careers to grow. We've discussed about black being overindexed over the last two years. I'm a real proponent of making sure that black, other ethnic minority groups are supported like gender, but they have to be identified as different groups because they have different needs. But what's really important is around the cultural evolution of organisations and making sure that each underrepresented group and the majority are catered for in terms of progression belonging. Because what we don't want to have is diversity fatigue, where the majority has sat there and think, Gosh, I'm over this already. So it's the fiduciary responsibilities of the board to change the culture, to educate, to support and provide the resources available for the majority, to feel part of that journey and feel a real sense of belonging.

    Roger [00:10:11] And within banking sales, trading in and the asset management industry, you know, we've seen that in the support roles is often a higher diversification. But isn't that quite a shockingly low number of people who are actually things like fund managers in the UK? And so in some ways there's still these tiers that need to be broken down and mix up a little bit more.

    Michael [00:10:29] Absolutely. And for those who don't necessarily know the stats, those who run money for us, portfolio managers in the United Kingdom, there are thousands of portfolio managers, five, six, 8,000 portfolio managers, and we've only been able to identify 14 black professionals running money. And it's a horrendous stat, an embarrassing stat, and one that the UK financial services have actually owned, recognised and want to do something about it. So again, it's about holding people accountable with regards to data. Because I've got no doubt, once we started to announce and educate that to some of the largest asset managers in the role in the world, they were mobilised, they were activated. So I think from that standpoint, it's around communication. And a number of organisations have developed programmes such as 10,000 black interns, which they've incorporated into their D&I strategy from a recruitment standpoint, but also looking at different industry verticals. So there's are an organisation that we worked with where we actually hired in traders into their from the from the sell side into asset management to help on the investment side. So organisations are looking to think outside the box.

    Roger [00:11:49] And then going forward, you know, the progress is starting to be made, the recognition is perhaps the sort of the first stage and starting to put in place some of those changes, but to build momentum. So this is something which, you know, we've seen starting today is there's the benefits of diversity, there's the commercial aspects of it, but actually building momentum so that in ten years time, it's actually that momentum is built. It's not just sort of started, we ticked a few boxes and then it ended. How does, what you see is that progression from here?

    Michael [00:12:18] Roger. I don't want to be in this seat ten years time. I do not want there to be chief diversity officers in ten years time. It's got around to be around cultural evolution, where we talk about acceptance, we talk about belonging, and ultimately it's all about diversification. So the next ten years are really about action points because there's going to be fundamental leaders in this space. We have seen a number of tech firms, organisations who have pushed back to banks and asset managers and said, if you do not have representation on your teams, we're not going to give you all business. That's where, and that's going to make the fundamental difference over the next ten years. Organisations are starting to hold their counterparties accountable.

    Roger [00:13:10] And do you think that this is something which, you know, we talked about this being potentially a global movement, this is something we're seeing here in the City of London, but is this this this culture, this this acceptance of diversity, is it something that you're seeing spreading out globally?

    Michael [00:13:25] Well, look, first and foremost, I think the UK economy, I think outside of the M25, the UK economy, the SMEs are doing an exceptional job of having diverse talent. Our cousins across the pond, in terms of the US in my opinion, are more advanced in terms of financial services in the major hubs, but are slightly underweight when it comes to other vertical sectors like technology VC. But the fact that we have an opportunity within financial services to change the dial, and really be a beacon to other industries, I absolutely believe is there. And I absolutely believe there's upside over the next 10 to 15 years.

    Roger [00:14:05] And if you've got any questions about this episode, the economy or financial markets, please put them in the comments section or send them to fmt@lseg.com