Moreover, the calendar-year high/low range for VIX is the narrowest since 1995.1
But how long will this trend last? It may be worth reviewing three indicators that can drive the direction of equity volatility. (These indicators should ideally be considered apart from geopolitical events, which can spike volatility on a shorter-term basis.)
What affects equity market volatility?
1. Corporate earnings
Corporate earnings have historically been inversely related to equity market volatility. That is to say, as corporate profits rise, equity volatility has tended to decrease. As the graphic below illustrates, corporate profits are increasing, with second-quarter 2017 earnings per share for companies within the S&P 500 Index up 20.7% on a year-over-year basis, after hitting a low of $23.06 in December 2015.2
2. Monetary policy
In addition to its impact on the economy, monetary policy can affect the health of a company’s balance sheet, access to capital and investment opportunities. Historically, there has been about a two-year lag between initial increases in the overnight federal funds rate and equity volatility, as shown in the chart below. Why is this germane now? As the graphic below illustrates, the US Federal Reserve (Fed) started to lift the federal funds rate in December 2015. The two-year anniversary of that shift in monetary policy is fast approaching, which could lead to higher equity volatility in 2018.
3. Credit spreads
Credit spreads — the difference in yield between corporate securities and US Treasuries — are a third factor influencing equity volatility. When the cost of corporate debt increases, it becomes more expensive for companies to access capital. Investment costs can rise as a result, which can make it difficult to return money to shareholders. By contrast, falling credit spreads, which imply lower corporate yields, make for less-costly access to capital. It then becomes easier to return money to shareholders.
Currently, credit spreads are compressed worldwide. The quantitative easing programs instituted by the Bank of Japan and the European Central Bank (ECB) have created less opportunity for fixed income investors and have depressed long-term interest rates.
Quantitative easing is gradually unwinding in many developed markets. The ECB is expected to start tapering its bond purchases this fall, and the Federal Reserve is expected to reduce the size of its balance sheet in the coming months. This means that the Fed will likely reduce its total assets by selling government securities — a form of restrictive monetary policy.
What does this mean for investors?
All three of the factors above could put some upward pressure on fixed income and equity volatility. For the time being, overall volatility is low, owing to strong corporate earnings, relatively low interest rates and narrow credit spreads. However, it would not be surprising to see the conditions that produce higher volatility intensify into 2018, given the lagged impact of rising rates and the end of quantitative easing. Any slowdown in corporate earnings could exacerbate this trend.
Investors looking to manage volatility may wish to examine the lineup of low volatility offerings from PowerShares by Invesco.
1 Source: CBOE, as of July 31, 2017
2 Source: Standard & Poor’s, as of July 31, 2017
Blog header image: Rodolfo Arpia/Shutterstock.com
Earnings per share (EPS) refers to a company’s total earnings divided by the number of outstanding shares.
Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.
The federal funds rate is the rate at which banks lend balances to each other overnight.
The BarCap US Corporate High Yield to Worst – 10-Year Spread Index is a measure of the risk premium present in the high-yield corporate debt market.
The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
An investment cannot be made into an index.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The fund’s return may not match the return of the index. The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
In general, equity values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Shares are not individually redeemable, and owners of the shares may acquire those shares from the fund and tender those shares for redemption to the fund in creation unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 100,000 or 200,000 shares.
There is no guarantee that low-volatility stocks or ETFs will provide low volatility.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
The PowerShares S&P 500 High Dividend Low Volatility Portfolio (NYSE:SPHD) was unchanged in premarket trading Wednesday. Year-to-date, SPHD has gained 4.12%, versus a 11.30% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.