Trump, The Low Volatility President
Perhaps the most unanticipated and mind-boggling development in financial markets since the Subprime Crisis has been the market reaction to Donald Trump’s election as U.S. president. For months prior to the election, Trump was seen as the pariah among contenders for the White House – the populist, untested candidate whose policies remain vague and which can best be described as hopeful promises. While Trump’s programme is enticing, and we hope he manages to influence Washington for the better, the correlation between Trump and financial markets is tenuous at best. Vague presidential rhetoric comprised of phrases such as “phenomenal tax plans” or “rolling back regulation” sound really nice. And in a stock market where any resemblance of positive news is a reason to buy, Trump will continue to get credit for the current move off last November’s lows. But objectively, one man will not stroll into Washington and change singlehandedly the establishment. While Trump may be sincere in his promises, as seen by pushing forward with the travel ban from Muslim countries, the president alone can not implement his programme without
getting Congress (or the judiciary system, in this case) on board. Herein lies our suspicion with the sustainability of the current equity rally, if all these equity gains are indeed based on hopes that Trump’s plans will be enacted lock, stock and barrel.
What is even more difficult to understand than the equity rally is the drop in volatility. Ok, yes equity markets are going to price in today any possible future good news right away. It has always been the nature of equity investors to buy the rumour and then sell the news. But given the rather extreme uncertainty surrounding Trump’s programme, and how he will “fit in” among the Washington establishment, should the VIX have touched its lowest level since 2007 this past week? Is there really that little fear on financial markets? On the contrary, we think that there remains significant apprehension among investors and that the VIX is not an accurate measure of “fear” today. The near record low VIX measure is not necessarily translating into complacency among the investing public, many of whom still have bitter memories of the 2008-2009 market meltdown. Our WMA U.S. Market Risk Indicator, for example, already hit its record high back on December 13th & 16th and is coming down sharply in perhaps an early alert for those shorting volatility products (VXX).
We went back to see historically how the VIX “fear index” behaved around the election of prior new presidents. In each case since Kennedy, we have seen some form of VIX reversion to the mean (from either above or below) during the new president’s honeymoon period (election to 100 days in office). As shown in the charts below, Trump’s honeymoon period has seen both the lowest pre- and post-inauguration levels in the VIX, as well as (for the moment), the absence of any mean reversion. One possible reason for the exceptionally low VIX currently has less to do with Trump and more to do with the absence of alternative investments to U.S. equities. Remember the VIX is just a measure of S&P 500 option volatility. But this can only be a partial explanation as relatively less attractive European equities have similarly just seen the VSTOXX index fall to two-year lows. Near historic or multi-year lows on many world equity volatility indexes would seem to be a conundrum.
The first chart shows the VIX index thus far under Trump. The VIX has essential remained below 14 for over three months. We have never seen VIX readings this low as a new U.S. president has taken office. The 11.2 average daily close on the VIX since Trump’s inauguration does not seem to reflect the uncertainty hanging over markets today.
S&P option volatility under Obama was heavily influence by the environment in which he took office. High pre-inauguration volatility gave way to falling post-inauguration volatility.
George W. Bush, like Obama, took office during a recession in the wake of a stock market burst. The VIX was anything but steady during Bush’s honeymoon period.
Clinton took office after the small recession in the early 1990s and as equities were ramping up for the longest U.S. equity bull market in history. Volatility nevertheless did swing around quite a bit falling towards 11 and spiking to 16 a few times.
As VIX data is not available prior to 1990, we calculated our own measure of S&P 500 implied volatility. Volatility during George H.W. Bush’s honeymoon period again showed some mean reversion, falling from high pre-inauguration levels to lower post-inauguration levels.
Our volatility measure was not low and stable when Reagan took office.
We also saw equity volatility swing lower then higher as Carter began his term.
Nor was equity volatility calm at the start of Nixon’s term.
Finally we saw a similar shift down in volatility under Kennedy’s honeymoon period just as with George H.W. Bush. Markets enjoyed relatively low volatility as Kennedy began his term, but nowhere as low as we have seen under Trump thus far.
The historical volatility comparisons from a new president’s election through the 100 days in office suggest that the current VIX behaviour is indeed unprecedented. Chalk this one up as another of the many market anomalies we have to deal with today. This VIX phenomenon ranks up there with Italian bonds yielding less than U.S. T-Notes, despite the enormous risk differential. In our view, not too many people really understand what is happening on financial markets today. And those who believe that they understand the irrationality are probably the most clueless. While central bank financial engineering is the root cause of market anomalies today, few can even fathom the future repercussions of mispricing risk over several years. This is not a bold statement, as similarly very few in 2007 understood the intricacies of bad subprime debt and the pervasiveness of toxic loans throughout the financial system. Trump is on track to take the crown as the new low volatility president. Despite now being in uncharted territory both in terms of monetary policy and fiscal policy, perhaps “this time is different” and volatility will remain extremely low with Trump this year. But then again, these four words, “this time is different”, have proven repeatedly to be the four most expensive words in finance.
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