The unusually low level of stock market volatility has drawn widespread attention recently as the crowd tries to decipher what it means for equity investing and the economy. One of the interpretations is that low vol is a sign that recession risk is low. That’s true, at least at the moment. But the historical connection between market volatility and the business cycle is too unstable for drawing general lessons about recession risk. In other words, it’s dangerous to assume from volatility alone that the near-term outlook for the US economy is rosy. The opposite is true too: a spike in vol by itself doesn’t always signal a new recession.
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The explosion of financial research in recent years has uncovered an expanding assortment of alpha-generating possibilities that presumably offer a shortcut for enhancing returns over and above a market index. But as a growing list of studies reminds, you can drive a bus through the gap between the reported laundry list of factors and those that pass the smell test.
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The so-called fear gauge of the US equity market – the VIX Index — fell to a two-decade low this week. Analysts are divided on what it means. By some accounts, it’s the calm before the storm. But others say it’s a sign that the good times will roll on, at least for a while.
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Tepid economic growth in the first quarter is on track to revive in Q2, according to estimates from several sources. Although the forecasts are wide-ranging at the moment, the unifying factor is a widespread view that output will pick up in the second quarter after a sluggish start to the year.
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Equity markets in developed countries ex-US rose sharply again last week, posting the biggest increase among the major asset classes for the five trading days through May 5, based on a set of exchange-traded products.
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The pace of job creation picked up sharply in April, the Labor Department reports. The solid increase suggests that the weak gain in March, which was revised down, was an anomaly. That’s an encouraging sign, and for the moment it revives the view that the US labor market is still expanding at a healthy if unspectacular rate. Nonetheless, the latest numbers also reaffirm that the year-over-year comparison is still signaling a decelerating trend, which has been playing out over the past two years.
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Credit Spreads, Daily Business Cycle, and Corporate Bond Returns Predictability
Alexey Ivashchenko (University of Lausanne)
May 4, 2017
The part of credit spread that is not explained by corporate credit risk forecasts future economic activity. I show that the link with aggregate business risk and bond liquidity risk explains this finding. Once I project spreads on these two risk factors, which are readily measurable with the daily frequency, in addition to corporate credit risk, the forecasting power of the residual spread reduces substantially for some macro variables and disappears entirely for the others. Such residual, however, turns out to be an out-of-sample forecast of corporate bond market returns. An investment strategy based on such forecasts delivers risk-adjusted returns 50% higher than the corporate bond market.
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Technology shares have taken the lead over stumbling financials in the one-year-return column, based on a set of proxy ETFs as of yesterday (May 3, 2017). Although financials are still sitting on a solid one-year gain, tech’s annual rise has moved decisively into first place among the major US equity sectors in recent days.
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The leadership of US equities in the horse race among the major asset classes is a sight to behold. By almost any yardstick, the stock market for the world’s biggest economy has been and remains a dominant force of financial nature among global markets.
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