Over the past couple of weeks, we’ve heard much talk about a shallow correction in risk assets following the recent shakeout and associated flare-up in market volatility. Will the prior turmoil prove to be isolated and short lived, or was it a sign of more sinister things to come? Months before his departure from the Fed, Alan Greenspan reminded us that: “Long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress.” He later warned that: “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
How should investors position for higher volatility?
In this report (PDF attached), we present some of the indicators we’ve found helpful for assessing the general direction of volatility and the risk-on / risk-off trade over the years. They include commercial and industrial (C&I) loan growth at all commercial banks (lagged 3 years), the slope of the 2s10s U.S. Treasury yield curve (lagged 2 years), and the CBOE Volatility Index (VIX). If we’re correct in our judgment that the recent de-risking is just the first of similar episodes to come, history suggests investors would be wise to favor the U.S. dollar over other major currencies & commodities, Treasuries over credit & equities, investment-grade credit over high-yield credit, and large-cap defensive sectors over small-cap cyclical sectors.
Check out the charts inside,