Volatility Investing -Inflation & Volatility Risk Premium
Portfolio Manager, Volatility and Overlay
Written in February 2022 by Simon Aninat, Portfolio Manager, Volatility and Overlay
Inflation & Volatility Risk Premium
As we start 2022, inflation is the hot topic in the investment community. Most people think that high inflation means high volatility for risky assets. Does that mean that investors should stay away from strategies extracting the volatility premium by selling implied volatility? We disagree, and here is why.
Who does remember the 60’s and 70’s “good old days”?
If we look at US CPI data and S&P500 returns since the 60’s, there is no evidence of a higher S&P500 realized volatility when the CPI was high. On the contrary, during “deflation” periods, often associated to recessions periods, realized volatility is structurally much higher.
Source: Seeyond, Bloomberg
The relationship between inflation and Equity volatility is obviously more complex than just the level of inflation. If inflation is high but growth expectations are also high and 10Y nominal treasuries yields are stable, Equity volatility has no reason to rise. It all depends on the growth environment and investors anticipations of how Central Banks will react to this high/rising inflation. The problem with Central Banks is that meetings and wording are not continuous processes. They try to gradually change their wording and guidance, but most of the time, the market tends to react in an ON/OFF mode, triggering sudden and sometimes quite large nominal treasuries yield moves. These sudden up moves tend to increase Equity volatility, but in a much smaller way than sudden down moves on yields. The chart below shows the rolling 1M change in 1M realized volatility (RV) versus the Z-Score of 1M change in nominal 10Y Treasuries yields since 1965.
When the “mean” is much higher than the “median”, it means that large “tail risk” or “black swan” values have pushed the mean way above the median value. We can see that rates rising fast cause much less volatility “spikes” than rates falling fast.
So, where does this popular belief comes from?
Still, in most investors mind, higher inflation will mean higher volatility. And even if we have seen above that Equity index volatility is quite unlikely to rise much, there is a rationale behind this popular belief. When we look at the correlation between the S&P500 and the US 10Y yield since the 60’s, we see that during high inflation regimes, the correlation tends to be negative, meaning that when the S&P500 sinks, US 10Y yield increases, which means that US 10Y Govies sinks. In a 60/40 portfolio, it means that Govies and Equities move in sync and the overall portfolio becomes very volatile.
Source: Seeyond, Bloomberg
In the past 20 to 30 years, we got used to Govies being a natural hedge to Equities within 60/40 portfolios. But it was not the case before the 90’s and in the recent past, with inflation being on the rise, this correlation has started to switch, and most investors are worried that we may re-enter into a late 60’s and 70’s regime where inflation was on the rise and Equities and Govies were moving in sync. In that context, if you cannot rely on Govies to “proxy-hedge” your Equity portfolio, you need explicit hedge, which means that you will need to buy protection options on Equity indices to protect your Equity portfolio. This should lead to a structural demand for implied volatility and should increase the richness of the volatility premium.
Inflation usually means Dispersion
Another reason why Equity index shouldn’t rise too much lies in index construction. Equity indices are usually a capitalization weighted average of many stocks. Let’s take the example of the S&P500 index. Amongst the 500 stocks of the index, some are positively affected by inflation, and others negatively. Large and diversified indices like the S&P500 are quite polarized on inflation sensitivity these days. Which means that when an inflation news hits the tape, some stocks are rising aggressively, and some stocks are selling-off aggressively. But overall, the index doesn’t move much. This high dispersion of stocks mechanically reduces the volatility of Equity indices. To illustrate and quantify this, we can look at the difference between the capitalization weighted average stocks volatility of index members and the index volatility. As correlation within an index is capped at 1, this difference is always positive and represent the “Correlation Discount”. As we can see in the chart below, in 2021, where inflation started to be the hot topic, stock volatility was at 27.1%, the second highest since 2011, when the index volatility was the 4th lowest since 2011. The correlation discount has been the highest in a decade, mostly in our view, due to the high dispersion brought by inflation uncertainty within index members.
What does it mean for Volatility Risk Premium strategies?
Main risks from investing in Volatility Risk premium strategies: Capital loss, Equity risk Volatility, model risk, exposure to financial derivatives and sustainability risks.
The main source of alpha of Volatility Risk Premium strategies is the spread between implied and realized volatility. In average, over the long term, this spread is positive, due to the loss aversion bias of investors. Investors are ready to pay a premium to be protected against large sell-off. This is the why this volatility premium exists and is here to stay.
Inflation mechanisms are complex and take time to develop. It will take month if not years to see exactly how things unfold. Until then, we should see increased demand for implied volatility and counter-intuitively contained index realized volatility thanks to large dispersion within the index between inflation winners and inflation losers. Both effects combined should mean “higher than average” expected return for Volatility Risk Premium strategies in the months to come.
This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.