Everyone understands that Washington’s current budget battle will create near-term market volatility. But many market watchers expect the volatility to be a temporary phenomenon that dissipates as soon as this latest episode of the fiscal soap opera is over.
I don’t agree. In my opinion, there’s a good chance that recent volatility may be here to stay for the long term. Here’s why:
Volatility over the past year has been unusually low. Most investors enjoyed a relatively quiet summer. In fact, since the fall of 2012 – with the exception of a brief scare last December around the fiscal cliff – US market volatility has generally been well below average, at least compared to the last twenty years. This is true regardless of the measure used, and the same holds for many other developed markets as well.
Part of the reason lies with monetary policy. The combination of the Federal Reserve (Fed)’s QE3, the European Central Banks’ OMT, and the Bank of Japan’s asset purchase program has gone a long way towards placating investors and suppressing market volatility.
The budget battle is likely here to stay for a while. Another reason for the past year’s low volatility: Other than the brief scare last December, there were few political or policy issues to rattle markets. In other words, there is a link between political and policy risk and market volatility. As you would expect, higher uncertainty over policy tends to be associated with more market volatility.
The relationship is strong enough to quantify. Over the past two decades, changes in the Economic Policy Uncertainty Index (EPUI) – an index of political risk and policy uncertainty – have explained roughly 20% of the variation in the VIX Index (a measure of the implied volatility on the S&P 500).
For most of the past year, the EPUI has been moving lower. However, beginning in late summer, the indicator started to increase as the noise around the budget battle heated up. The measure increased by roughly 60% from August to September, and the September jump suggests that, all else equal, volatility (i.e., the VIX) should be two or three points higher than the prevailing level in August. In addition, should the indicator move back to the levels witnessed during the summer of 2012 – a real possibility as there are also political rumblings in parts of Europe – this would suggest that the VIX will rise to the high teens, closer to its long-term average.
And as there’s a very good chance that Washington will produce yet another temporary patch to avert a default (for example, a hike in the debt ceiling that only lasts three months), we’re likely to be back in the same position a few months down the road.
In short, if political uncertainty over the budget and debt ceiling becomes a semi-permanent fixture, market volatility is likely to remain higher than the summer’s placid levels. Under this regime, investors may need to reacquaint themselves with what a more volatile world feels like.