What if risk assets are heading lower, not higher?
Over the past couple of weeks, we've heard much talk about a shallow correction in risk assets following the recent shakeout and associated flare-up in market volatility. Will the prior turmoil prove to be isolated and short lived, or was it a sign of more sinister things to come? Months before his departure from the Fed, Alan Greenspan reminded us that: "Long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress." He later warned that: "History has not dealt kindly with the aftermath of protracted periods of low risk premiums."
In this article, we present some of the indicators we've found helpful for assessing the general direction of volatility and the risk-on / risk-off trade over the years. They include:
- Commercial and industrial (C&I) loan growth at all commercial banks (lagged 3 years);
- The slope of the 2s10s U.S. Treasury yield curve (lagged 2 years);
- The CBOE Volatility Index (VIX).
Consider the relationship between the CBOE Volatility Index (VIX) and the S&P 500 index. The last time we wrote about it (September 29, 2011), the VIX was approaching a second major peak of 45.45 (October 3, 2011) and the S&P 500 was falling to a nearby low of 1099.23 (October 3, 2011). Fast-forward six months: Stocks rallied 29% from their October lows to their April highs (1419.04 on April 2, 2012) and volatility fell below 15 in the same timeframe. Over the past several years, whenever volatility has fallen to such low levels and complacency has reigned supreme, it has left risk assets vulnerable to negative shocks. Today, the list of downside risks for stocks is long: Spanish and Italian debt concerns, the recession in Europe, China's growth trajectory, the outlook for synchronized global central bank liquidity support and, in the U.S., slowing earnings growth, future spending cuts and tax hikes, to name a few.
Next, we highlight the slope of the 2s10s U.S. Treasury yield inverted and lagged two years versus the VIX. While it's far from perfect, there are a few ways to think about this relationship. First, the yield curve is one of the 10 leading economic indicators. In general, a flatter yield curve points to more challenging economic conditions down the road, higher volatility and bad news for economy-sensitive segments of the markets.
Second, when the Fed approaches the limit of zero lower-bound policy stimulus and can neither steepen the curve nor underwrite risk any further, eventually, high-beta assets begin to feel the downward pull of economic gravity. We would point out that the curve has flattened significantly from a high level which in the early-1990s and 2000s was followed by multi-year flatteners and heightened market turbulence. In fact, the last time we wrote about this relationship was early-March 2007 and we were on the leading edge a significant bout of higher volatility and pronounced investor risk aversion. Food for thought.
Take a look at commercial and industrial (C&I) loan growth at all commercial banks lagged three years alongside the VIX. At first glance, the link between these two variables might seem counter intuitive: If credit is the lifeblood of the economy, why would faster loan growth coincide with higher readings on the VIX? However, it's important to note that we're talking about lagged C&I loan growth, meaning volatility follows the credit cycle by a few years. In our minds, it's the prior buildup of leverage and its subsequent unwinding that sets the stage for a bumpier ride ahead. While the household sector has delevered considerably, judging by the sharp decline in the household financial obligations ratio and household debt service payments as a % of disposable personal income, federal government debt has gone parabolic in order to finance excess spending and a large budget deficit. From this perspective, the rapid reacceleration of C&I loan growth suggests we have yet to feel all the aftershocks of one of the biggest credit bubbles in history.