RQA Economic Insights: August 2024 — Richmond Quantitative Advisors

RQA Indicator Spotlight: equity market volatility (fear gauge)

In this months indicator spotlight, we take a summary look at the equity market “fear gauge” or the “VIX” index. The VIX, or CBOE Volatility Index, is a widely recognized measure of the market's expectations of volatility over the next 30 days, derived from the prices of S&P 500 options. Often referred to as the "fear gauge," the VIX provides a snapshot of investor sentiment, capturing the level of anxiety or calmness in the market. When the VIX is high, it indicates that investors anticipate significant price swings in the market, often driven by uncertainty or fear. Conversely, a low VIX suggests a more stable market outlook with lower expected volatility.

*Sources: Norgate Premium Data; Quandl, Inc.*

The Three Levels of the VIX as a Market Gauge

Understanding the VIX involves recognizing its three key levels, each indicating different market conditions:

Low VIX (Below 20):

A VIX below 20 is generally associated with calm market conditions and steady investor confidence. In these periods, the market is typically experiencing stable or rising prices, and the risk of sudden downturns is perceived as low.

Moderate VIX (20-30):

When the VIX rises into the 20-30 range, it signals increased market uncertainty. This level often coincides with periods of market fluctuations or anticipation of potentially disruptive events, such as earnings reports, economic data releases, or geopolitical developments.

High VIX (Above 30):

A VIX above 30 indicates heightened fear and expected volatility. This level is often seen during market crises, corrections, or major news events that disrupt normal market functioning. High VIX levels suggest that investors are bracing for significant price swings, often to the downside.

*Sources: Norgate Premium Data; Quandl, Inc., and RQA.*

Calculating Implied Market Moves from the VIX

The VIX, expressed as an annualized percentage, can be translated into expected market moves across various timeframes using implied volatility. To estimate the daily move, divide the VIX by the square root of 252 (trading days in a year). For weekly moves, use the square root of 52 (weeks in a year), and for monthly moves, use the square root of 12 (months in a year).

For example, if the VIX is at 20:

Daily Move: About 1.26% (20/sqrt(252))
Weekly Move: About 2.77% (20/sqrt(52))
Monthly Move: About 5.77% (20/sqrt(12))

These calculations provide insight into expected volatility over different time horizons, helping investors understand market sentiment and potential price swings.

Analyzing VIX Overlaid with the S&P 500

To illustrate the VIX's relationship with the market, consider a chart with VIX levels overlaid on the S&P 500 index. The chart typically shows the VIX moving inversely to the S&P 500: when the S&P 500 declines, the VIX tends to spike, reflecting increased fear and uncertainty. Conversely, when the S&P 500 rises, the VIX generally falls, indicating investor confidence and lower expected volatility.

Market Reactions:

Key instances, such as the 2008 financial crisis, the 2018 "Volmageddon," or the 2020 COVID-19 market crash, highlight how VIX spikes align with sharp declines in the S&P 500. Periods of low VIX often correspond with market stability or rallies, suggesting a more optimistic or complacent investor sentiment.

Why Monitoring VIX Levels is Important

Monitoring VIX levels provides valuable insights into market sentiment and risk dynamics. By keeping an eye on the VIX, investors can:

Anticipate Market Moves: High VIX levels can serve as a warning of potential market turmoil, prompting more cautious positioning or hedging strategies.
Assess Risk Appetite: Changes in the VIX help gauge shifts in investor risk appetite, which can inform tactical asset allocation or timing decisions.
Identify Opportunity Zones: Extremely low or high VIX levels may indicate potential opportunities for contrarian plays, as markets may revert from overly complacent or fearful conditions.

Current Market Context: Recently, the VIX has fluctuated dramatically, moving from around 15 to over 50 during a period of heightened uncertainty, driven by factors such as recession fears and the unwind of the yen carry trade. These sharp movements reflect the market's rapid shifts in sentiment—from calm to intense fear and back again. Monitoring these VIX levels provides critical context for current market positioning and expectations, highlighting the importance of staying vigilant in such volatile environments.

Conclusion

The VIX is a powerful tool for understanding market volatility and sentiment. By tracking VIX levels, investors gain insights into the market’s mood and potential risks, aiding in more informed decision-making. Whether used for risk management, speculative trading, or general market assessment, the VIX remains an essential component of any market analysis toolkit. In the current environment, with the VIX's recent dramatic swings, staying vigilant on its levels could provide timely cues for navigating the evolving market landscape.

Economic Forecast Model

As of the end of July, the growth metric in Richmond Quantitative Advisors’ Economic Forecast Model stood at 0.20, marking a decrease from June’s revised figure of 0.38. This reduction, down from 0.43 in May, primarily reflects a weakening labor market and signifies the third consecutive month of diminished output from the model. As the growth forecast nears the zero bound, adopting a cautionary stance is advisable should positive momentum fail to resume in the upcoming months.

*Source: Analysis by RQA. Data from U.S. Federal Reserve; Bureau of Labor Statistics; Norgate Premium Data; Institute for Supply Management.*

The RQA Economic Forecast Model represents a consolidated composite of key economic leading indicators and market-based explanatory variables. The goal of this composite model is to present a holistic measure of primary U.S. economic growth drivers and their trends over time. (Additional detail on the model’s construction is provided here.)

Values above the zero-line are indicative of positive U.S. economic growth expectations in the near-term, and therefore, indicate economic strength and lesser chance of recessionary pressure. On the other hand, values below the zero-line represent the opposite - a more negative outlook and more elevated probabilities of the U.S. experiencing an economic contraction.

TAKING A CLOSER LOOK AT THE ECONOMIC DRIVERS

In the economic heatmap below, we are able to peak under the hood at a wide mix of underlying growth drivers in the U.S. economy. By reviewing this underlying data in more detail, we are better able to see how the underlying components of the U.S. economic growth picture are behaving through time. The indicators presented below have each proven to have predictive qualities in estimating the future direction of U.S. economic growth.

In the last few months, economic data had several notable trends and movements across various sectors highlight the mixed conditions in the market. The labor sector shows signs of volatility, as evidenced by the RQA Labor Composite, which decreased from 0.9% in June to -1.4% in July. This shift, accompanied by a significant decrease in initial unemployment claims from a positive 2.5% to -6.3%, indicates an increase in job losses and suggests instability in employment conditions.

The commercial output presents a mixed picture. While the Industrial Production Index improved modestly from 0.3% in June to 1.7% in July, signaling a slight uptick in industrial activities, both the ISM Manufacturing PMI and ISM Services PMI experienced declines, pointing to potential challenges in manufacturing and service sectors.

Income and consumption data reflect a high but slightly declining trend in Real Personal Incomes, decreasing from 8.4% in June to 7.9% in July. Conversely, retail sales continued to contract, worsening marginally from -0.8% to -0.9%, indicating ongoing consumer caution in spending.

Financial indicators show significant trends, particularly in the Treasury Yield Curve Spread between the 10-year and 2-year notes, which narrowed from -0.4% to -0.2%. This movement suggests a yield curve that is close to uninverting, hinting at changing investor expectations about future interest rates and economic conditions. Meanwhile, inflation metrics such as the Consumer Price Index (CPI) saw a slight decrease from 3.3% to 3.0%, which could signal a stabilization in inflationary pressures.

MARKET REGIME DISCUSSION

Markets have stabilized following the volatility shock at the beginning of the month. Risk assets have rebounded, while traditionally safer assets like Treasuries have stayed within a consistent range. Current market reactions to soft economic data and sharp currency market fluctuations seem to stem more from technical factors rather than signaling a prolonged converging event.

During his latest speech in Jackson Hole, Fed Chair Powell reiterated that inflation is steadily declining towards the Fed's 2% target, now at 2.5%, and confirmed anticipated interest rate cuts in the near future (September). He noted that the labor market has returned to pre-pandemic levels, bolstering hopes for a soft landing—easing inflation without inducing a recession. Powell acknowledged the unique challenges of the pandemic economy, advocating for a flexible, data-driven approach to future monetary policies. He also admitted to initially underestimating the inflationary pressures, advocating a cautious approach moving forward.

On the economic growth front, the RQA forecast model reacted to the same data that influenced market dynamics at the start of August. The model has registered a decline for the third consecutive month, inching closer to the "no growth" threshold, signaling caution for near-term economic expansion.

As for the economic quadrant output, with both inflation and growth rates declining, our regime model currently resides in the inflationary boom quadrant but is moving back toward the zero bound for both inflation and economic growth.