FINANCIAL MARKET ANALYSIS

Since October 2022, investors have been willing to take greater risks with their assets. This greater tolerance of uncertainty, known as 'risk-on', has led to a steady rise in the equity markets, which have gained around 50% in just over 18 months. Investor confidence is also evident in volatility indices and bond markets. Stock dispersion (VIX), measured by the standard deviation of returns on the 503 stocks that make up the S&P index, is now close to historic lows (see Fig. 2). Similarly, yield spreads between corporate and Treasury bonds have literally collapsed. The premium paid to bondholders for the additional risk of default has rarely been so low.

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Taking the analysis a step further, it is easy to see that the volatility of volatility (VVIX) has also fallen to an abnormally low level, as this 73% level has only been seen temporarily in the past (see Fig. 3). Mathematically, a moment of investor panic is becoming increasingly likely, which would bring the volatility indices (VIX and VVIX) back above their respective medians, at 17% and 90%.

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On the bond markets, spreads have compressed across all issuer qualities. The best-rated US companies, known as investment grade, now offer just 125 basis points of additional yield compared with 10-year government bonds (see Fig. 4). Their counterparts with a greater risk of default, known as high yield, pay a coupon of "only" 350 basis points more than Treasuries. The low level of these spreads is especially striking given that the yield on "risk-free" assets has risen sharply in recent years. The best way to illustrate this phenomenon is to calculate the contribution of spreads as a percentage of the total yield delivered by corporate bonds. The weight of spreads has almost never been so tiny (see Fig. 5).

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In addition to the fact that investors' risk appetite is not linear, and that a 'risk-on' environment can very quickly turn into a 'risk-off' one, two macro-economic factors call for vigilance : ‍

▪ Economic activity is slowing, particularly job creation (see Weekly Investment Focus of 6 May 2024), which could cause leading activity indicators to fall, even before they have managed to get above the fateful 50-point threshold (see Fig. 6). With less growth meaning less earnings for companies, their ability to reward shareholders and pay down debt would deteriorate. As a result, volatility and credit spreads would increase.

▪ Monetary policy is restrictive in order to prevent inflation from spiralling out of control. The rigour of central banks tends to provoke periods of turbulence on the financial markets (see Chart of the Week). Given the speed and scale of the rise in key rates, it is highly likely that volatility and spreads will rebound structurally over the next two years.

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Conclusion :

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It is when the sea is abnormally calm that the sailor must identify the ports of retreat. For investors, this means considering sovereign bonds and hedging strategies before an economic and financial storm causes spreads to widen and volatility to rise.

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