As low volatility persists Goldman recommends buying high yield. Published on: Jul 6, 2017 @ 09:46
Only a day after Goldman Sachs’ analysts published a report noting that the current low volatility environment is unlikely to come to an end until a Black Swan event hits the markets, today another group of the investment bank’s analysts published a report claiming “as long as the level of growth remains strong, we think the low vol period and the gradual grind higher for equities are likely to continue.”
The report goes on to consider the best assets to hold in a prolonged low volatility environment.
High Yield Is The Best Asset For Low VIX Environment
Historically, overweight equity and underweight government bonds has been the best performing combination. However, “the big difference now relative to history is that low rates have led to most assets being expensive, which will constrain returns across asset classes, in our view.” With interest rates rising, equities are unlikely to suffer, as long as growth remains strong, but the same is unlikely to be true for fixed income. Once again, historically low vol periods have seen positive returns for government bonds as coupon income has offset any capital losses from rising rates, but this has been different this time given much less coupon income. The one area of the market that still looks attractive to Goldman’s analysts is high yield where the carry still looks attractive. The longer the low vol cycle, “the more likely it probably is that spreads gradually grind tighter.”
High yield then is Goldman’s pick to outperform against the low vol backdrop. Interestingly, the outperformance of US high yield credit compared with other asset classes is not unique to low vol periods. Based on data going back to 1991 Goldman notes, “80% of the time US HY credit has better risk-adjusted returns than the S&P 500, and they are 4 times as large on average.” The report continues, “the difference in risk-adjusted returns is primarily due to the materially lower volatility of US HY – it generally has vol significantly lower than even US Treasuries. This tends to be driven by the negative correlation between credit spreads and risk-free rates as we are considering total returns.”
Traders are betting that the low VIX will not persist for much longer. Last updated Jul 5, 2017 @ 09:46.
After an extended period of low volatility, investors are beginning to position for higher volatility, that’s according to a new research note from Goldman Sachs published at the beginning of this week. The report, penned by Goldman’s economic’s research team headed by Christian Mueller-Glissmann, CFA, notes that during the past few weeks investors have begun to aggressively position for higher S&P 500 volatility. Demand for VIX calls has increased sharply. Meanwhile, inflows into the largest long VIX ETP (iPath S&P 500 ST future, VXX) have picked up and the net short on VIX futures has decreased. The VIX call/put ratio has spiked to one of the highest levels since the great financial crisis. All of these developments point to one conclusion; investors are positioning for more volatility and a higher VIX.
But are traders likely to be rewarded any time soon?
Traders Being To Bet That Low Volatility Will Soon End
Goldman’s report notes that while volatility has picked up in recent days thanks to hawkish comments from central banks around the world and geopolitical concerns, bouts of low volatility can last for extended periods and there’s no telling when the current low volatility regime will give up its grip over the markets. Since mid-2016 the S&P 500, in particular, has been gripped by low volatility and one month realized volatility fell to 7% during June, the 11th percentile since 1928.
According to analysis conducted by Mueller-Glissmann and team, since 1928 there have been 14 similar episodes of severely depressed volatility where realized S&P 500 volatility was generally at or below 10 and volatility spikes were short-lived. On average these periods of low volatility lasted nearly two years, and the median length was 15 to 16 months. However, there were several periods in the 50s, 60s, and 90s that lasted more than three years. The report goes on to note that in all of these scenarios, markets benefited from a “Goldilocks scenario,” a very favorable macroeconomic backdrop with strong growth and favorable inflation— it can be argued that such an environment is present today.
Unfortunately, trying to predict the end of such “Goldilocks” backdrops is quite difficult. The report notes that historically, volatility spikes have been hard to predict as they often “occur after unpredictable major geopolitical events, such as wars and terror attacks, or adverse economic or financial shocks (e.g. the Euro area crisis), and so-called ‘unknown unknowns’ (e.g. Black Monday in 1987).” To put it another way, there’s no accurate way of forecasting the event that will bring an end to ultra-low volatility. Going off this evidence, traders’ actions to go long volatility might be an indication that the low-vol regime is not going to come to an end anytime soon as it’s general complacency that poses the most significant risk for financial markets.
Low Vix series last updated on 6/26/2017
Low volatility periods can last for up to 18 months according to Goldman Sachs.
Volatility, or rather the lack of it, has been one of the most talked about topics on Wall Street for the past few months. Analysts have been trying to dissect why the market has become so calm of late, and what this means for future returns since the beginning of spring. As of yet, there’s been no definitive answer to the question and some new data from Goldman Sachs suggests that the current bout of low volatility is not all that abnormal after all.
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Goldman’s 20 June Global Strategy research booklet, focuses on the topic of volatility. The report’s authors, look at the current state of volatility compared to historical averages and consider the best asset allocations to take advantage of the current environment.
Goldman: Low Volatility Periods Can Last For Upto 18 Months
The most interesting data concerns the market environment during past low volatility periods. Goldman’s researchers find that low volatility periods are not as unusual as they may seem, and even though S&P 500 1-month volatility has now been below the 50th percentile (13%) for 185 days and below the 25th percentile (10%) for 131 days, there have been 15 similar low volatility periods since 1928.
What’s more, according to research these periods tend to last for 18 months on average, thanks to a supportive economic backdrop resembling a “a ‘Goldilocks’ scenario of improving growth with anchored rates and inflation, similar to now.” The longest period was in the 1990s, when the S&P 500 increased for nearly