In recent conversations, we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):
"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012."
Given many pundits have been discussing the steepness of the VIX curve and the inconsistency of the implied volatility with credit spreads, we thought this time around, we would focus our attention on "European Equity Volatility" and the European counterpart of VIX, namely V2X, courtesy of our Global Macro friends at Rcube and join the "passionate debate".
But first some interesting charts -1 year evolution of VIX versus its European counterpart V2X - source Bloomberg:
10 year German Bund yield versus 10 year US Treasury note yield - source Bloomberg:
The divergence between US and European PMI indexes - source Bloomberg:
Moving back to the title of our post, we completely agree with the recent note from our good friends at Rcube Global Macro Research namely that:
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates.
For credit availability, we use the central banks’ credit surveys. For the Eurozone, the % of banks tightening their lending standards spiked to 35% in Q4. In itself, this argues for a higher volatility regime from now on."
Hence, another reason, we think, (like our friends do), of tracking the lending surveys from the ECB:
Rcube Global Macro Research - 19th March 2012
Clearly as indicated by Rcube:
"Equity volatility is also logically driven by the direction and the magnitude of revisions of forward earnings estimates. In 2010 and again last year, equity vol spiked while earnings forecasts remained strong."
This previously helped my Rcube friends to identify that the spikes in volatility were not sustainable:
"We therefore used them as selling opportunities (unfortunately not aggressively enough this year). Nowadays, earnings’ forecasts estimates are slowly weakening."
V2X and Eurostoxx 50 Earning Revision - source Rcube Global Macro Research - 19th March 2012:
Rcube also added in their note:
"A combination of weaker earnings forecasts and tighter credit access is pushing the fair value of our European equity volatility model higher."
And according to our friends at Rcube:
"The deviation from fair value is plummeting and could get close to triggering buy signals if earnings based information deteriorate further."
Rcube Global Macro Research - 19th March 2012
Our friends at Rcube also indicated in their note:
"Recent data regarding the European credit channel showed that LTRO could be positively modifying bank lending behavior. Last week, the French Treasurers’ Association survey showed that both the cost of credit lines and their availability had improved. Nevertheless, it remains too timid to have a meaningful impact on the model."
In relation to the VIX, for the V2X, our Rcube friends also agree with many VIX pundits, namely that:
"The V2X term structure is so steep that it doesn't yet make sense to go long volatility. We're currently near all-time highs regarding the term structure".
So, clearly, the steepness of the V2X makes it very expensive to go long volatility in Europe as well.
In fact, our friends at Rcube have measured the average return of going long the VSTOXX Short-Term Future index:
"The following back test shows that in the fourth quartile, the average return of going long the VSTOXX Short‐Term Futures Index is around ‐8% on a 1 month horizon."
We already touched on the relationship between credit and equities (A tale of two markets - Credit versus Equities). As indicated by Rcube, availability of credit can be tracked via the ECB lending surveys and can be used to give clear indication of the "sustainability" level of volatility in conjunction with revisions in earnings forecast estimates.
"Just as a cautious businessman avoids investing all his capital in one concern, so wisdom would probably admonish us also not to anticipate all our happiness from one quarter alone."