Market Volatility Moving Forward?
Saturday, September 30, 2006 at 10:45PM 
The FT's lex column has a small but telling synopsis on market volatility and especially whether we should expect more of it as we go forward with a slowing US economy. Lex begins by citing a BIS study which notes that volatility in fact has been quite low for the past three years.
According to a recent study by the Bank for International Settlements, volatility from mid-2004 to March 2006 was notable because it was low for a prolonged period, simultaneously, across different assets in both industrial countries and emerging market economies. The BIS believes part of the reduction is structural.
However this, I think, might well be about to change. The overall point is that conventional wisdom these days are being revised by the hour as suggestions of whether global interest rates might have peaked or not go hand in hand with whether headline inflation will spillover into core inflation. In fact, I am banging my head on this one at the moment. Globalization has surely held core inflation down but also raised the headline measure; if this is the highest level of interest rates we can expect from the Fed, ECB and BOJ going forward, what are we going to see then? Stagflation seems a real possibility in the US.
Pantom from Golden Age makes a thoughtfull comment on this in one of my recent post ...
'I thought the classical discourse on this was that it would keep inflation up because of all those commodities increasing in price.'
Clearly this is part of the story but only a part since there is also a reverse effect contained in the same set of dynamics producing the inflation spike in commodites and assets.
. In the recent print edition The Economist has an interesting article (Hat tip New Economist) which attacks this issue albeit from a different perspective; namely the Phillips Curve. The magazine points to a flattening of the curve ...
'A flatter Phillips curve is good news when unemployment is falling. But it also implies bad news if inflation rises significantly. It would then take a much larger increase in unemployment (a more severe recession) to bring inflation down again. This may explain why the European Central Bank has found it so difficult to get euro-zone inflation back below its target of 2%.'
The Economist also points to this which has also been articulated by Kenneth Rogoff.
'The Federal Reserve may focus on the low core rate of inflation but workers may be watching the headline numbers, which in most countries have been significantly higher. The sharp drop in oil prices in recent weeks may reduce this differential, but could easily be reversed by supply disruption or a harsh winter.
If workers begin to focus on the effect of higher commodity prices on their spending power, and regard the effect as permanent rather than temporary, then they may push up their wage demands. That could lock higher inflation into the system, giving central banks a devil of a job to bring it back down again.'
So a preliminary conclusion here would go something like this:
Since it now seems that the US economy, the Eurozone and Japan all are facing a slowdown the risk as articulated by recent posts in blogland this might very well turn into stagflation, at least if we follow this from a theoretical point of view. However, the first very important point here in terms of the global economy is to distinguish between the US economy on the one side and The Euro and Japanese economy on the other side. As such the argument above derived from The Economist's article might end up fitting the US but not in the Eurozone (some countries!) and Japan where population dynamics make the risk for deflation higher mainly due to fiscal tightening in the immediate horizon. In terms of the US and the idea of stagflation especially Nouriel Roubini seems to think this is a real probability particularly if expectations begin to adjust to headline in stead of core inflation.
I am not, to say the least, sure about this analysis. I feel that it contains the right components but perhaps they are not rightly macthed?
Reader Comments (1)
Number one is volatility. In my personal investing, I have always considered low volatility to correlate, over the medium to long term (one to four years out from its occurence) to be bullish for the stock market, at least. If you look at a long-term chart of the VIX ( http://finance.yahoo.com/q/ta?s=%5EVIX&t=my&l=on&z=m&q=l&p=m200&a=&c= ) for the US market with the 200 day moving average for it thrown in, you can see a definite cyclical movement in it, and the way I read it is that low volatility is a precursor to higher stock prices, rising or falling volatility is coincident with rising prices (the 1996-1999 period for the rising side, the 2003-2005 period for the falling side) while high volatility is a precursor to falling prices, as the high volatility of 2000 came just before the sharp falls of 2001 and 2002, which of course kept the VIX high once they started to happen. All of which is a long way of saying that historically low volatility that then begins to rise is about as bullish an indicator as there is, in my opinion, and that's what we have now. I've been investing with this in mind for more than twenty years in all kinds of different markets, and while the record isn't perfect, it's good enough that I pay close attention to it.
As for the economy, while I agree we're headed for an economic slowdown, I don't think a recession is in the offing. My chain of reasoning is: stagflation isn't going to happen, therefore neither is recession.
As I argued in my previous comment, the difference this time from the stagflationary seventies is tightening labor markets leading to higher productivity as a long-term trend, at least here in the US. See the St Louis Fed's Business/Fiscal Statistics Page ( http://research.stlouisfed.org/fred2/categories/1 ), and the series "OPHBS", business sector output per hour for all persons. I run an 8 year moving average on the year-over-year change in this series, based on the recent length of US business cycles (reasoning below), and on that basis productivity is now running at a fairly consistent 3% pace. Productivity at this level is not an indicator of stagflation; far from it. The stagflation of the seventies was accompanied, after all, by consistently falling productivity, to a lowpoint of an 8 year average of just slightly above 1% by the end of the decade.
Therefore, two things: the NAIRU will continue to run lower than most economists think, probably around 3-4%, and Roubini and The Economist I believe are getting it wrong about stagflation. I think we're going into a period of flat inflation and may even see some year over year price declines as a commodity cyclical bear gains momentum (I do believe that this is a bear in a longer term commodities bull that began back in 2001, but that's a different story). That kind of kills the stagflation thesis during this coming slowdown. Probably economies will come to a standstill, but I don't see outright GDP decline.
Doubting a recession is a logical consequence of doubting the stagflation thesis. If you look at the NBER's economic cycle research for the US ( http://www.nber.org/cycles/cyclesmain.html ), you'll notice we've had two very long cycles, that trough to trough were 100 and then 128 months in length. In the sixties, there was one of 117 months in length, followed by three shorter ones during the "stagflation" era of the seventies.
So, from all that, it would appear that shorter cycles these days only happen if you can argue that stagflation is coming. As I doubt that thesis, I also doubt that this cycle will be a short one. The trough was Nov 2001, a mere 59 months ago. So, I think we still have a few years to go before we see outright recession, at least here in the US.
What we have right now is normal market action. The slowdown has already caused falling commodity prices and interest rates, the latter regardless of what the Fed, which is irrelevant right now, does. This is the opposite of what you would expect in a stagflationary environment. It's just plain normal.
There will likely be rising volatility in the markets, though, but that's just fine with me, and would actually be, once again, merely normal.