War or recession might be needed to break low volatility; Goldman Sachs puts chances of recession in the next two years at 25%

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Published: July 5, 2017 11:41:57 AM

It’ll take more than central bank tightening to shake volatility from its yearlong slumber, according to Goldman Sachs Group Inc.

goldman sachs, recession, 25% recession, economy, world economy, goldman sachs group, markets, equity markets, Christian Mueller, Alessio RizziGoldman Sachs puts the chances of a recession in the next two years at 25 percent. (Reuters)

It’ll take more than central bank tightening to shake volatility from its yearlong slumber, according to Goldman Sachs Group Inc. A large shock such as recession or war is usually required. That’s generally been the case for the 14 similar low volatility “regimes” since 1928, at least in equity markets, Goldman Sachs strategists Christian Mueller-Glissmann and Alessio Rizzi said. These periods on average lasted nearly two years, featured short-lived spikes and realized S&P 500 volatility was usually at or below 10. Swings picked up across assets in the past week and investors are positioning for a shift higher, in part because of fears of central bank tightening, the strategists wrote in a July 3 report. But a sustained breakout is unlikely without an escalation in uncertainty or recession risk, they said.

“Volatility spikes have been hard to predict as they often occur after unpredictable major geopolitical events, such as wars and terror attacks, or adverse economic or financial shocks and so-called ‘unknown unknowns’ (e.g. Black Monday in 1987),” London-based Mueller-Glissmann and Rizzi said. “Recessions and a slowing business cycle have historically resulted in a high vol regime across assets.”

Goldman Sachs puts the chances of a recession in the next two years at 25 percent.

Low volatility isn’t unusual and tends to stem from a favorable macroeconomic backdrop with strong growth but anchored inflation and rates, similar to a “Goldilocks” scenario, Mueller-Glissmann and Rizzi said. Markets have reflected this since January, with equities reaching record highs, strong global growth and declining bond yields, they said.

The risk investors face near-term is a consolidation but no transition to sustained high volatility, and to guard against this, Mueller-Glissmann and Rizzi recommend protection through put spreads.

Also Watch:

97%-93% 1-month S&P 500 put spread trades at sixth percentile cost based on last 18 years and offers max payoff of >16x in case of a >7% drawdown

Asset allocation

Equities: Neutral over three months as little return potential and risk of consolidation; stay overweight for 12 months Bonds: Still underweight on both 3- and 12-month horizon “We believe that in the near term, the risk/reward for vol selling strategies has worsened but find it difficult to be long the VIX owing to the high cost of carry”

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