With the recent large swings in equity markets, the correction in risk assets feels bigger than it actually is. Volatility, as measured by the VIX (Figure 1) shot up by the most, up 34% yesterday, since 2011.
Image courtesy of Stockcharts.com
Figure 1: VIX
Uncertain Italian election results added to the list of worries for investors. Furthermore, Washington appears willing to allow automatic spending cuts to go through, increasing the government's drag on economic growth. Yet, none of these seem to have changed investors' risk preference over the past few months.
In Italy, cyclical sectors continue to outperform the market. Industrial stocks are up 5.2% year-to-date, compared to the MSCI Italy 1.4% loss. Even financials are up 4.4%, signaling investors' confidence in Italian banks. Meanwhile, 2-yr Italian bond yields remain below 2%. Clearly the market is not signaling a breakaway from the eurozone by Italy, regardless of the election results. It is also clear by now, given that Greece is still in the eurozone, that the pain of leaving is very high yet concessions are given to those who stay. So long as the ECB stands ready to prevent a breakup of the eurozone, the odds of another eurozone crisis are low. Finally, the high yield bond sector (Figure 2) has yet to show any sign of divergence, unlike in 2011 when it signaled a weakening economy. The drama in Washington is unlikely to push the world's largest economy into recession anytime soon. With the sharp spike in the VIX index, we are probably nearer to the end of the correction, rather than the beginning of a larger market sell off.
Image courtesy of Stockcharts.com
Figure 2: High yield bond relative to US Treasuries
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