It's the volatility, stupid?

It is a nerve-wrecking period for investors, both professional and amateur (including anyone with a pension fund), as concern over the likelihood of a US -- and perhaps global -- recession led stock markets around the world to suffer their largest falls since September 11, 2001.

This pushed the Federal Reserve unexpectedly to cut its overnight lending rate by 75 basis points, markets to price in a further 50 basis point rate cut at this week's Fed meeting, and Bush administration officials to hint that they would consider an even larger stimulus package than the 150 billion dollars that has been proposed. Meanwhile, Fed and government officials are at pains to emphasise that while the United States is in the middle of a slowdown, they do not believe this will spill over into a full-blown recession.

Dates of US recessions and anti-recession stimulus packages
Beginning	End	Legislation enacted	Course of Action
Source: New York Times
Nov-48	Oct-49	Oct-49	Advance Planning for Public Works Act
Aug-57	Apr-58	Apr-58	Federal Aid Highway Act
		Jul-58	River and Harbor Act, Flood Control Act and Water Supply Act
Apr-60	Feb-61	May-61	Area Redevelopment Act
		Sep-62	Public Works Acceleration Act
Dec-69	Nov-70	Aug-71	Public Works and Economic Development Act Amendments
Nov-73	Mar-75	Mar-75	Tax Reduction Act
		Jul-76	Public Work Employments Act
		May-77	Local Public Works Capital Development and Investment Act
Jul-81	Nov-82	Jan-83	Surface Transportation Assistance Act
		Mar-83	Emergency Jobs Appropriations
Jul-90	Mar-91	Dec-91	Intermodal Surface Transportation Efficiency Act
		Apr-93	Emergency Supplemental Appropriations Act
Mar-01	Nov-01	Jul-01	Economic Growth and Tax Relief Reconciliation Act

Markets did not immediately respond to the Fed announcement, but there were subsequently some signs of recovery.  While particularly negative economic and market forecasts may be overstated, volatility is likely to be the watchword.

The 'fear index'

A look at the Chicago Board Options Exchange's Volatility Index (VIX), the US index of implied volatility known as the 'fear index', shows that the market is expecting increased turmoil (a high number suggests greater turbulence, and a low one calm). Rising volatility raises the price investors have to pay to hedge risk. The VIX is higher than it was last year, so the cost of hedging equity positions has risen.

However, the levels reached last week may be higher than they have been recently, but they are still low; the VIX's all-time high, Black Monday in October 1987, was 171.52.

This increased volatility has implications across the globe:

United States

Even if the Bush administration increases its economic stimulus package, the White House’s preferred tax rebates focus on middle class and wealthy individuals, rather than the working poor.  Rather than being designed to stimulate consumption this would aim to stimulate enterprise creation, which is unlikely in the current climate.  Therefore, their impact is likely to be limited.

United Kingdom

In the United Kingdom, which a severe US downturn would hit particularly hard, the housing market has slowed somewhat, but remained relatively resilient.  Growth in retail and consumer spending has been lacklustre, with a number of major retailers experiencing substantial sales slumps.  Moreover, while unemployment remains low, the City and financial sector are in distress, laying off staff.  Therefore, there is little prospect of credit becoming more readily available, meaning that residential property prices are likely to flatten -– or even fall, which could have knock-on effects in the rest of the economy.  Economic distress in the United States would make an already negative outlook even worse, particularly as continuing weakening of sterling could limit the Bank of England’s scope for rate cuts because of fears that they could exacerbate inflationary pressures.

Emerging markets

Severe drops in Asian and other emerging markets suggest that recent bullish commentary that increasing 'decoupling' could help shield from the effects of a US downturn may be misplaced.  Fears that US economic distress could be worse than expected, combined with concerns about Chinese bank exposure to US sub-prime debt, will continue to drive pessimism.

Even if markets do recover from the latest period of turmoil, this is likely to be a 'dead cat' bounce during a bear market.  Further volatility is likely, particularly given that money markets will remain tight, and further write-downs from financial institutions and downgrades of bond insurers are likely to trigger additional declines.