“Risk is the feeling of disutility caused by uncertainty.” That is the definition I learned at Chicago in business school and it has stuck with me for the last 30 years. Most of all, I like that it frames risk in personal terms (“how do you feel?”) and anchors those around perceptions of probable outcomes (“how sure are you?”).
Take yesterday’s market action as one example:
- “Uncertainty” about the pacing of US-China trade talks hit global stocks, rallied bonds and pushed the Chinese offshore yuan (our favorite “trade tell”) ever further away from its old 7.0/$ ceiling to close at 7.04.
- At the same time, markets do not yet “feel” much “disutility”, believing both sides must come to some agreement sooner rather than later. President Trump doesn’t want a December stock market meltdown a la 2018, which crimped last year’s Holiday spending. President Xi may never have to worry about the ballot box, but a slowing Chinese economy and heightened tensions in Hong Kong should encourage him to come to the table. Or so the thinking goes…
- The result: the market’s most closely watched “risk” indicator, the CBOE VIX Index, barely budged. It closed the day at essentially unchanged at 12.8, more than 1 standard deviation (6) from its long run average (19).
The VIX, however, isn’t the only risk measurement game in town. We can use the implied volatility (what the VIX measures for options on S&P 500 futures) imbedded in options chains for a variety of ETFs that track industry groups and various asset classes.
Looking at how options markets have priced the last month’s IVs, we see a clear picture of just how the market got to its current seemingly “whatever, man” complacent stance:
- US large cap Industrials have seen their “VIX” drop by 35% in the last month. While not as exposed from a revenue standpoint to global trade as other sectors, this group does have very high fixed costs. A 2020 global economic recovery sparked by a trade deal would therefore help the group generate higher profits.
- The “VIX of” Tech and Financials have also come down more than the S&P 500 by 16%/12% respectively versus 11% for the index as a whole. Tech is heavily exposed to non-US revenues (more than any other group), and Financials should benefit from renewed global growth.
- Rate sensitive groups – Utilities, Consumer Staples, and Real Estate – have all seen their “VIXs” rise in the last month. No point in playing in defensive groups if global growth and interest rates are set to rise.
About the only fly in this otherwise optimistic ointment is the notable increase in the “VIX” of Emerging Markets. At +50% exposure to China + Taiwan + South Korea, it should be lower if a trade deal is really at hand, but as the chart below shows it has risen by 8% in the last month. The MSCI is only +2.3% in the last month, notably lagging the S&P 500’s 4.1% advance. We can only assume that markets believe a trade deal is more helpful to the US economy than EM.
Summing up: if you are less than 100% confident in a US-China trade deal in the near future, you need to be lightening up on risk exposure right now. Markets think this pie is baked, cooled and ready to serve. For better or worse, we remain confident both in a trade deal and a better 2020 global economy. But we understand reasonable people can differ on that point; risk is a feeling, after all.