GLOBAL MACRO OUTLOOK

Learning to live with low vol

jul 27, 2017

Digging into U.S. equity volatility patterns dating back more than a century, we find low market vol can last for years and tends to overlap with subdued macroeconomic vol. Combined with our view that the U.S. economic cycle has room to turn, we believe this environment helps foster risk-taking.

Highlights

  • Realised U.S. equity volatility has historically stayed low for remarkably long periods of time. Importantly, volatility does not follow a normal bell curve distribution. Instead of volatility having a single ‘equilibrium’ level, we believe it is better viewed as operating in different regimes: often low, sometimes high.
  • We find U.S. GDP data form similar realised vol patterns to those of the equity market –and both regimes tend to be long-lasting. High equity vol regimes can be fleeting, with no echoes in the economy. It is the overlapping market and macro shocks that are the most fraught with potential systemic danger.
  • We are vigilant on potential vulnerabilities in the financial system but believe post-crisis regulation and periodic bursts of anxiety (eurozone woes, China scares, commodity slides) have kept asset froth in check. We do not see systemic risk as high but are on watch for any stealth leverage build-up.

Low-vol regimes, when U.S. equity volatility averages 10%, can last for years. Sporadic spikes happen, but they are temporary and do not cause a change to a high-vol regime (22% volatility). See the chart below. Running a regime-switching analysis on data since 1985, we find a 90% chance that any low-vol regime will persist from the current month over the next 12 months. What triggers a switch? The economy is key. U.S. equity and macro vol regimes tend to overlap, apart from the 1987 equity plunge and 1998 market seizures. Those episodes were short-lived and did not feature high macro vol.

Regime change
U.S. equity and GDP volatility regimes, 1985-2017

U.S. equity and GDP volatility regimes, 1985-2017

Sources: BlackRock Investment Institute and BlackRock's RQA team, with data from Robert Shiller and the U.S. BEA, July 2017.
Notes: Realised volatility is calculated as the annualised standard deviation of monthly changes in U.S. equities over a rolling 12-month period. Using a Markov-Switching regression model, we calculate two vol regimes: a high-vol regime (orange) and a low-vol regime (green). The orange and green lines plot the average vol level during each regime based on a broader sample from 1872 to 2017. We use the same regime methodology for U.S. GDP based on annualised quarterly data.

 

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Jean Boivin
Head of Economic and Markets Research
Jean Boivin, PhD, Managing Director, is Head of Economic and Markets Research at the Blackrock Investment Institute.
Ed Fishwick
Global Co-Head of Risk and Quantitative Analysis
Ed is a managing director and Global Co-Head of Risk & Quantitative Analysis at BlackRock.