Asset Allocator: May2015- Chart Watching: Sterling and Volatility levels under the microscope

In his latest weekly Asset Allocator post, David Stevenson focuses on the Foreign Exchange market and Indices which track stock market volatility looking towards the chart in order to investigate whether GBP is over-vauled and what has become of market volatility and whether a resurgence could be imminent.

The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes no responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear. 


 ASSET ALLOCATOR: MAY 2015

18/05/15- Chart Watching: Sterling and Volatility levels under the microscope 

 

This week I want to focus in two fascinating markets – the FX markets and especially sterling as well as Indices which track stock market volatility. In particular four charts are of huge interest to this observer – within the FX space I’m interested in two pairs, the €/£ and £/$ while over in the volatility space I’m interested in the Vix and VFTSE indices. My own feeling is that sterling has become terribly over-valued and could be due a big bout of volatility while stock market volatility overall could by contrast remain remarkably becalmed for a great deal longer than any of us currently believe. VIX RIP?

Let’s start with the FX markets and the curious case of Strong Sterling. Over the last few decades we’ve all been led to believe that the big story about our beloved currency is that we’re mid-way through a huge depreciation cycle following the decline of empire!

The first chart below – using data from Sharescope – tells us one bit of this story, showing how the pound has fallen steadily from 1.7 euros to the £ to a low not much above parity. The cable trade – the pairing between the dollar and sterling – is an even more brutal tale with a multi decade decline from highs of $2.78 to the pound sixty years ago in 1955.

But the chart below also tells us another, more recent reversal, which involves sterling strengthening against the Euro. 

 

The next chart returns to the cable pairing – the £ and the dollar – and shows the rate from the beginning of the year, slumping sharply to a low of well under $1.50 to the £ to recent highs of not far off $1.60 to the £.

There are of course some obvious wider drivers at work – the strengthening dollar and the deliberate weakening of the Euro – but for me another less obvious story is that for much of the last decade sterling has remained TOO strong.

Our balance of payments situation should remind us that we are currently living way beyond our collective means. We have only a few limited choices moving forward to correct this balance – sell many more goods and services internationally, borrow more or sell a huge amount of hard assets to pay for this big structural deficit. My own sense is that a relatively strong pound has served some interests in the UK remarkably well – many in the City – but badly weakened our industrial base. If we are to rebalance growth moving forward – an avowed aim of nearly all major parties - we need a WEAKER not a STRONGER pound. Our huge government deficit is also increasingly being funded by external capital inflows, which might in turn cost us dearly as interest rates start to rise. 

  

My own sense is that UK factor inputs, especially around labour costs, need to be much more competitively priced as well as being more productive over the next decade and we probably need a weaker pound to compensate for this deep structural shift. But even if you don’t accept my logic, I think a more obvious argument is that investors might need to hedge out their foreign currency investment exposure because sterling could be in for a real roller coaster ride over the next decade. I’m not at all convinced that this current FX volatility – a strengthening pound – will somehow fade away, to be replaced by a more stable foreign currency regime.

And this mention of volatility brings me to my second clutch of charts based around measures of equity market volatility. The first is from the excellent Yahoo Finance service and shows the VIX index from the end of 2010 through to mid May 2015. Just to remind readers, the VIX is a classic fear gauge index, widely used by traders. It measures the turbulence of the benchmark US equity index, the S&P 500.

  

My second chart looks at a tighter time frame and focuses instead on the UK version of this index, the VFTSE. This, like the VIX, charts the day to day volatility of our own FTSE index. The data comes from the website (http://eoddata.com/stockquote/INDEX/VFTSE.htm ) and looks index values through to the end of May.

  

I don’t think it takes a degree in rocket science (or technical analysis) to notice a big story in these two charts – volatility has faded away, and these vol indices are trading at the bottom of recent trading ranges. In simple terms equity markets look relatively becalmed and steady. 

This observation immediately suggests a future outcome – investors are mightily complacent and we’re due a huge spike in turbulence, with the VIX for instance climbing past 25 or maybe even 35 following a big sell off. 

Maybe, but I suspect a rather more pedestrian explanation may be at hand. Markets are relatively quiet because central bankers want them that way. And unless something very big changes – for instance a massive increase in interest rates and/or inflation – volatility levels aren’t going to spike up any time soon. 

Amongst macro investor's within the hedge fund this idea has been gaining a fair amount of traction in recent months i.e many now believe that policy makers look very closely at indices such as the VIX volatility index in order to help shape their next policy moves. 

On one level this idea seems absurd as central banks should actually be focusing on good old fashioned measures like inflation and jobs growth. But maybe what is actually happening is that central bankers are now formally looking at volatility measures and thus when indices like the VIX shoot up, these economic policy makers deliberately crank up the money printing presses. 

Lurking beneath this controversial argument - put ably by commentators such as Richard Duncan of website MacroWatch- is that QE is specifically designed to boost stock markets. Rising share prices feed through into consumer spending and thus increased corporate profits. This in turn pushes the economy forward.

But when stock markets stutter and droop, volatility shoots up, confidence ebbs away again, and the central bankers have to step up the gas on QE again. If all this makes sense then I think we can begin to see why QE4 may be on its way. This might mean that if volatility in the US markets intensifies, helped by a strong dollar crushing US corporate profits, we could see the American Federal Reserve stepping back into the breach again with another bout of QE. The bottom line? Betting on equities rising is a decent bet because central bankers want to engineer rising equity prices.

The Wall Street Journal recently underlined this strange state of affairs by observing in an article called "volatility for stocks stays in Check"  that as the S&P 500 hits record highs, the benchmark US equities "hasn’t had a single move, up or down, of 2% this year, compared with three such swings by this time in 2014 and two in 2013.....To be sure, the S&P has posted more 1% moves so far in 2015 than it did in the corresponding period last year.  To be sure, the S&P has posted more 1% moves so far in 2015 than it did in the corresponding period last year".

We also all need to be realistic about what these volatility indices measure as well, namely implied future volatility - actual volatility has indeed crashed! Markets just aren't turbulent anymore. Current measures of volatility may just be telling us that we're probably still in a low-volatility regime - the VIX median in 2014 was 14, while the current median price level is around 15. Crucially we've spent most of the last five years under 20! So volatility is about where we'd expect to be over a long term average and maybe the markets aren't complacent after all!

If all of this sounds confusing, it is! Markets seem to be under the spell of central bankers. But investors looking to use investments in Vix based products as a hedge against future risk, also need to properly understand how these indices are constructed. 

Luckily a US website called ETF Trends recently put out what I think is the best, most concise  summary yet of how to understand the relationship between the VIX index and volatility.

“Here’s a question for you. If the market were to expect consistent 2% daily moves in the S&P 500 over the next 30 days, what approximate VIX level would we see? I won’t make you wait for the answer. VIX would increase to approximately 40. And to scale this down, expected 1% moves would translate to a VIX of about 20. In brief, that’s the “rule of thumb,” the round numbers to keep in mind: VIX at 40 = 2% daily changes; VIX at 20 = 1% daily changes. This is the math behind the numbers. VIX is a monthly measure of implied volatility that has been annualized. A VIX of 40 (or 40%) equals an expectation of 30-day volatility of 11.5%. This is done by dividing the annual number, 40%, by the square root of time*, in this case 12 months. To get to a daily volatility value, you have to divide by the square root of days in a year, 365. So, 40% divided by the square root of 365 is approximately 2%. And 20% divided by the square root of 365 equals about 1%". 

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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The indices referred to herein (the “Indices”) are not sponsored, approved or sold by Societe Generale. Societe Generale shall not assume any responsibility in this respect.

 

 

 


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