Are you surprised by VIX sub 10? You shouldn’t be. There is a direct linkage between liquidity and volatility as shown in the chart below.
Source: Bloomberg, Astoria Portfolio Advisors LLC.
This year, we have seen $2.2 trillion USD in central bank balance sheet expansion globally (approx. 15% of the aggregate balance sheet across the ECB, BOJ, and Fed). Right now, capital markets are swimming in an ocean of liquidity thanks to central banks flooding the system.
With low levels of economic uncertainty, low levels of earnings dispersion, and ample liquidity, it shouldn’t surprise investors that VIX is “low”. Moreover, there is a direct linkage between implied and realized volatility which reinforces another reflexive concept.
Several worlds are colliding. Earnings are improving, significant amounts of assets are moving into passive and systematic strategies (both of which deemphasize the capital markets aspect that active managers historically implemented), and dispersion is rising. This combination is resulting in lower levels of realized volatility. Reflexivity has been extreme.
The markets, however, trade on the margin and 2018 will begin to see liquidity decline in the US. The Fed has started to raise rates, wants to hike more, and quantitative tightening will further reduce liquidity. The repercussions are quite significant – especially on the margin.
It is not surprising that liquidity sensitive asset classes such as US high yield credit, US Small Caps, and Japan corrected in October/November. Historically, liquidity in capital markets starts to decline in Q4 as banks begin to wind down their balance sheet ahead of year end. Plus, we have the potential for another Fed rate hike in December. The “liquidity based correction” was likely in anticipation of both events.
At Astoria, we are watching financial conditions intensively – specifically the rate of change. We prefer watching financial conditions instead of the VIX because it incorporates financial stress in equities, bonds, money markets along with cost of credit. We don’t doubt that VIX will react quickly should financial conditions deteriorate.
As you can see from the chart below, the Federal Reserve Bank of Chicago’s National Financial Conditions index is near half a century low! If, on the margin, liquidity begins to decline in 2018 resulting from QT, fed rate hikes, and other central banks ending their QE programs, there is a reasonably high probability that risk assets will suffer. We doubt this “liquidity risk” is either consensus or built into the price.
Source: Federal Reserve Bank of Chicago, Bloomberg, Astoria Portfolio Advisors LLC.
What are the investment implications if, on the margin, liquidity deteriorates? While we have been vocal about our constructive outlook and our Multi Asset Risk Strategy ETF model portfolio has benefited accordingly (Sharpe Ratio over 3 this year), we are managing our risk appropriately by incorporating asset classes such has gold, liquid alternatives, and long dated treasuries. We have found these to be good portfolio diversifiers and carry well within a ETF portfolio construct.
Article by John Davi, Astoria Portfolio Advisors
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