The volatility factor

The slide in global markets over the last two weeks were precipitated by markedly higher volatility levels which first spiked when Chinese woes sent stocks on a tailspin back in February last. Higher volatility inflate risk premiums (no wonder it figures in the Black and Scholes option pricing model) creating havoc for certain segments of the markets. More volatility can also be a good thing, depending on how you are structured. With a sudden jump in the vix index, one of the first reactions tends to be a general flight to quality and the most recent market turmoil is a perfect example of this. Credit spreads have widened substantially as money has poured out of corporate and high yield bonds towards the safety of treasuries. There is also a move out of riskier emerging market stocks towards those of developed markets. We can add to this the switch from small cap to large cap although part of it is related to the advanced stage of the cycle. Finally, there tends to be sector rotation in favor of defensive industries such as consumer staples or health care during periods of high volatility.