by Goldman Sachs
Implied equity vol has declined further with the VIX closing at 16.4 on Friday, just above the 1-year low of 16.3 reached in April. While the VIX is still high compared to the pre COVID-19 period, a regression based on macro variables suggests that the current level is in line with the macro backdrop, with elevated macro volatility having been a speed limit for further normalisation (Exhibit 1).
Still, recent realised S&P 500 volatility has been remarkably low with 10-day realised at 7.2 - below the 10th percentile since 1970 (Exhibit 2). In February, equity volatility normalised alongside rising rates implied volatility, closing the gap from earlier this year (Exhibit 3). High and rising inflation has pushed up rates vol and resulted in positive equity/bond correlations, which also kept equity volatility elevated. However, rates volatility has recently started to decline - our economists expect the Fed to exit only very gradually from the easy current policy stance and near term, post the NFP, rates volatility might decline further.
Since the beginning of the year equity downside protection has been somewhat expensive - OTM S&P 500 puts have traded as more expensive vs. ATM, keeping normalised put skew close to all-time highs (Exhibit 4). Recently skew has started to come down due to demand for calls. This is particularly evident for single stock options, where the CBOE put/call ratio (the ratio between the traded volumes of puts versus calls options) is drifting towards all-time lows again (Exhibit 5). More sustained declines in equity volatility could drive increased positioning from systematic investors: elevated equity volatility YTD and the positive equity/bond correlations have likely constrained equity allocations for risk parity and vol-targeting investors. Likewise, the beta of CTAs to equities has declined, suggesting that they have reduced their exposure during recent range-bound markets (Exhibit 35).
We remain broadly pro-risk in our asset allocation although the macro backdrop is worsening with peak growth momentum and lingering high inflation - a continued vol-reset might increase vulnerability to both growth and rate shocks. We think the hurdle rate for a correction has declined with sentiment and positioning indicators picking up further - low put/call ratios point to a worsening risk/reward for equities in the near term. Risk reversals (sell puts to buy calls) look more attractive to get equity exposure due to high skew - compared to history they screen particularly cheaply for European equities (Exhibit 6). Alternatively, put spreads can help hedge correction risk, especially as we would not expect a sustained equity drawdown.
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