fool me TWICE
VIX Index, 10/1/2019 - 11/25/2022. Source: Yahoo Finance. Click for larger image
Stocks rose for a second consecutive month in November, cheered by lower-than-expected inflation and a speech by Fed Chair Jay Powell that hinted at a downshift in the pace of rate hikes. Recalling the peak of the other “pivot” rally this summer, the VIX index has once again settled into the lower end of its 2022 wedge (see chart) as the S&P 500 (+5.4% Nov) approaches its 200-day moving average.
In another flavor of the pivot trade, a massive rebound in ex-US stocks courtesy of a weaker US dollar generated the best single-month returns since inception for EAFE Smart Index (+11.6% Nov) and Emerging Markets Smart Index (+13.5% Nov) strategies, perhaps hinting at opportunities in a future lower-rate environment. One month does not make a trend, but moves of this magnitude are hard to ignore.
Managing a modest gain since mid-June, equity markets seem to be caught in an eddy of conflicting messages, swirling between the benign outcomes implied by some markets and recession signals from others. Most notably, even as high-yield corporate bond and VIX pricing continues to suggest hope for an imminent recovery, interest rate markets now see rate hikes turning to rate cuts by June of next year, implying a recession sometime in early 2023 (see chart below).
Fed Funds Expectations as of 12/2/22. Source: Federal Reserve Bank of Atlanta
Given the historical tendency for major VIX spikes following similar turns in monetary policy (chart below), this is perhaps the most critical divergence in markets today. From currently modest VIX levels and considering the magnitude of this year’s rate adjustment, its resolution may not pass quietly.
VIX Index vs Fed Fund Rate, 1990-2022. Source: St. Louis Fed. Click for larger image
Two Ways To Win
Equity Crisis Cycle. Source: TCM. For illustrative purposes only.
While stocks have historically risen over time, backward-looking, hyperactive monetary policy has created an “Equity Crisis Cycle” (see diagram) that can throw investors off course as each new crisis creates the potential for poor emotional decisions.
To address this issue, TCM designed strategies that focus on passive, index-level investments for strategic market exposure combined with tactical, “airbag”-like VIX exposures to lessen the impact of crisis periods. With two opposing positions, this approach was designed with two ways to win, either through beta generated by index exposures in a rising market or alpha from VIX exposures during a crisis.
As markets approach a critical juncture, this dual potential comes into better focus. Should the current cycle avoid recession as currently implied by the VIX and corporate bond markets, beta (equity exposure) is the likely winner as markets skip directly to the recovery phase and leave the VIX to wait for the next crisis. If instead, the cycle follows historical precedent and moves into the riskier recession environment implied by rates markets, then odds rise for potential VIX alpha before the recovery phase begins.
The best potential for VIX often comes from the “sticky” hedging demand created by a financial contagion and in a highly leveraged system, contagion spreads fastest through credit markets. To date, concern in this space has mainly focused on higher inflation rather than the default risk that creates contagion but as markets head into a potential recessionary minefield, this area bears close watching as a likely catalyst for the VIX. As always, we believe its collective wisdom is the best guide for portfolios.