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Don’t Be Lulled by Low Volatility

With the market’s so-called fear index trading at unseasonable lows, investors may be tempted to settle in for a quiet vacation. Don’t count on it.

For investors who closely monitor the VIX, which measures market volatility and is sometimes referred to as the “fear index,” recent readings may suggest it’s time to book that quiet summer vacation. 

Naturally, if you watch the VIX that closely, you also probably suspect that its current lows are unsustainable.  Something’s gotta give, even if you don’t know what it will be, or when it will hit.

Heading into the summer, a number of events may yet push market volatility higher.

After all, we’ve been here before. Remember how the euro crisis escalated in 2012, or when bond markets threw a taper tantrum in 2013, or when China’s central bank rejigged its renminbi regime in 2015? It’s precisely in times like these—during the lull—when investors should assess the risk of more turbulent markets to come.

For now, a strong earnings season on both sides of the Atlantic has left equity markets feeling reassured that investors and stock markets aren’t disconnected from fundamental reality. Meanwhile, on the policy front, central banks seem to be proceeding cautiously and communicating clearly. This has meant a gradual tightening policy at the Federal Reserve, and maintaining an expansionary stance at the European Central Bank.

What could go wrong?

As it turns out, heading into the summer, a number of events may yet push market volatility higher. For starters, both the Fed and ECB could still surprise markets at their respective June meetings. While a Fed rate increase and an ECB hold are considered highly likely, unexpected shifts in forward guidance, especially on balance-sheet policies, are a risk. A shrinking Fed balance sheet means weaker market technicals and smaller shock absorbers. Meanwhile, our U.S. fixed-income strategists highlight that both mortgage-backed securities and Treasuries will experience a sizeable swing in new issuance into positive territory next year.

Internationally, a set of factors, ranging from a further material decline in oil and commodity prices, an unexpected surge of protectionist policy measures, a sharp escalation in geopolitical tensions, or concerns about policy over-tightening in China, could reduce global risk appetite.

Equally, any indication that U.S. economic growth has failed to gain momentum in the second quarter would likely rattle markets. Indeed, a plunge in our real-time big-data activity indicator in the U.S. hints at a possible softening in second-quarter GDP tracking estimates. That could challenge the conjecture that the subdued hard data would eventually catch up with the relatively elevated soft surveys of consumer and business sentiment.

Against this backdrop, and with less liquid market conditions over the summer in mind, our cross-asset strategists looked at the implications of the VIX temporarily falling below 10. They argue that such historically low volatility—while in sync with other risk and volatility metrics—is unlikely to be sustained. Looking at historical market performance, they found that equities usually do okay in the wake of such low VIX readings and often only experience modest declines.

They also note that such low-volatility periods have persisted for at least two to three months, in the current context, just in time for the summer vacation season in many countries, which is why investors might want to hedge against unexpected market moves before they head off for their holidays.

Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (May 14, 2017) series. Ask your Morgan Stanley representative or Financial Advisor for the latest macro and strategy coverage and reports. Plus, more Ideas.