Volatility the name of the game

Proving that volatility really is the name of the game S&P futures are pointing to a drop at the open, after yesterdays bounce back. A risk-off day in Asia, with all major indices posting losses at the time of writing, treasury yields slipping lower and havens, the yen and gold gaining ground. Australian stocks sliding once more into a bear market after the turnaround Tuesday comeback.

The VIX remains above 40 and in this heightened volatility regime 3% days, both to the upside and downside, will be the new normal. The extremes of Monday’s historic sell off may be a rarity, but with VIX remaining significantly above the long-term equilibrium, alarm bells are still sounding and traders should be wary of relief rallies.

Erratic swings are exacerbated by the present high volatility regime. This combined with above average volumes and lower liquidity, which is highly negatively correlated with volatility, creates a self-perpetuating feedback loop and increase in systematic selling that exaggerates daily price movements. So when volatility picks up larger trading ranges are driven by falling liquidity and the expansion in trading ranges is not only to the downside, but to the upside as well. This as panic deleveraging and forced selling on the downside is countered by short covering, bargain hunting and policy action on the upside.

To have real confidence in buying into any relief rally volatility needs to reset meaningfully lower. And more clarity surrounding both the economic consequences of measures to control the spread of COVID-19 as well as the stimulus hopes is needed. It is too early to tell whether the health crisis will develop into a more serious global financial/credit crisis or how deep and dark a recession would be. But confidence is frail and the fear of the unknown and prospect of aggressive economic shutdowns is enough to keep risk assets under pressure. After all how can we discount a recession or recession in corporate earnings without knowing the scale of the health crisis or true impact. There will come a time for bargain hunting, but we are inclined to wait it out a little longer. For now we focus on capital preservation and tactical trading opportunities thrown up by volatile price swings and temporary relief on panic monetary and fiscal policy action upside.

Although equity markets will eventually look past the inevitable hit to earnings presenting opportunities for long term investors, we have not yet reached that point. The COVID-19 outbreak continues to spread globally and as transmission increase, so does fear. In many countries the outbreak is only in its infancy and as such the economic ramifications of measures to prevent the spread of the virus are only just beginning. Nobody knows what the eventual outcome will be here, but the longer it takes to contain the COVID-19 outbreak the more aggressive containment measures will be presenting ever increasing risks to economic activity and raising the possibility of a broad scale economic meltdown in the worst case scenario.

The case count in the US just reached 1,000 today, but by means of reference the US is testing 5 per million persons and South Korea is testing more than 3000 per million persons. This would indicate that the case count in the US is likely vastly understated. Another factor permeating fear throughout financial markets and the broader community is the evident struggle as governments try to balance containment and downside for the economy. Primarily focusing on fiscal stimulus packages or market falls, utmost importance for a president who views stocks as a real time indicator of his stewardship, rather than containment. While it is good to see both fiscal and monetary stimulus measures, the initial response is likely to be underwhelming and the relief short lived.

Although stimulus packages may ease downside risks to the economy, for markets to really recover the onus will be on reduced COVID-19 transmission rates, increased immunity and a clear containment of the outbreak, only then will the downside risks to economic activity diminish, a long way off at this stage. Widespread testing has not been available in most developed countries, lockdowns and travel bans have not been stringent enough or come quickly enough to prevent spread, preventative measures are slow to roll out and health care systems are likely to be overloaded with patients suffering severe complications. A failure of most governments and health officials that leads to a serious erosion of confidence beyond the economic ramifications. The elevated uncertainties and lack of control are obliterating confidence, we see this in the pandemonium that has erupted in supermarkets as consumers panic buy essentials.

A major problem here is the hit to sentiment and therefore demand cannot easily be reversed by monetary or fiscal policy. Whilst consumers are fearful of the threat of a global pandemic confidence will be hard to restore, hence why containment efforts are so important in supporting confidence.

Cash handouts or tax cuts which have been discussed will be relatively ineffective if consumers are scared about losing their jobs during this protracted period of economic uncertainty. Meaning the propensity the save any cash handout will be increased whilst a global pandemic is looming. This is why it is paramount for governments to consider maintaining job security, or sick pay as focal point in any stimulus response.

In addition to limit layoffs from business facing a meaningful temporary hit to operating incomes, emergency financial support like delayed tax payments and credit lines so as to limit cascading knock on effects to other businesses could be considered. This is key to protecting jobs and avoiding a more broad based financial shock so that supply and demand can bounce back more quickly once the COVID-19 crisis eases.