Will there be a recession? Here’s what market volatility is telling us.

What happened?

If you have been following movements in the US stock market, you would have noticed the recent spike in market volatility. 

This came about after US government bond yields surged to the highest levels since 2007 as the Federal Reserve warned that interest rates may stay 'higher for longer'.

The CBOE Volatility Index, also known as VIX, rose to above the psychogically important 20 level for the first time in four months earlier this month. 

While the VIX has since moderated slightly to about 17 as of 11 October 2023, it has led to questions about whether the spike in VIX is signaling a potential recession in the US. 

Let us understand more about the VIX to find out. 

Why are stock market investors concerned about a recession?

For equity investors employing a top-down approach, concerns about the potential for a recession, particularly in the US, often loom large. 

To underscore this, one only needs to recall the bursting of the IT bubble in 2000, during which the S&P500 index plummeted by a staggering 49% from its 2000 peak to its 2002 low. During the global financial crisis in 2008, the index collapsed by a staggering 56%. On both occasions, recessions ensued.

The link between these market downturns and recessions is rooted in a fundamental cause: when the Federal Reserve tightens monetary policy by raising the fed funds rate, it withdraws liquidity from the financial system. 

When this tightening occurs aggressively, it generates substantial headwinds for equities, ultimately elevating the risk of a recession.

As such, it's important to find indicators that can serve as early warning signals for a US recession. 

What is the VIX?

Imagine you're planning a sailing trip. Before you set sail, you'd probably want to check the weather forecast. You'd especially want to know if there's a storm coming, so you can decide whether to delay your trip or set sail with caution.

The stock market also has its own "weather forecast" called the VIX, which was introduced by the Chicago Board Options Exchange (CBOE) in 1993.

Instead of predicting rain or shine, the VIX measures how "stormy" investors expect the market to be in the near future.

VIX stands for Volatility Index. Without getting too technical, it's an indicator that shows how much investors expect the stock market to swing up or down in the next 30 days.

When the VIX number goes up, it means investors are expecting more dramatic ups and downs in stock prices. Higher numbers can indicate more uncertainty, worry, or even fear about the market's future movements. 

On the other hand, a low VIX suggests calm waters ahead — investors are feeling more confident and expect fewer surprises.

How can the VIX be used? 

So, how can investors utilize the VIX to anticipate US recessions? Is the VIX a reliable predictor of these economic downturns? 

At a time when concerns about the US sliding into recession are prevalent, we believe that tracking the VIX offers a swift and straightforward method for gauging the risk of a US recession. 

One notable advantage of this indicator is its daily publication and easy accessibility, making it a user-friendly tool for both seasoned and novice investors alike.

What is the VIX telling us currently?

The chart above provides a snapshot of the VIX's performance up to last week, revealing a striking pattern. 

Note that the VIX is shown on a reversed scale above. This means that a higher VIX number would correspond to a slower pace of GDP growth in the chart. 

Throughout the entire year, the index consistently remained outside the zone associated with recessions. 

This clear trend strongly suggests that the widespread fears of an imminent US recession in 2023 are likely misplaced. 

Notably, even though the Federal Reserve significantly raised interest rates over the past 12 months, the fear index never surpassed 25 since the beginning of the year. 

While there was a brief spike to 26 in early March, prompted by the collapse of several large regional banks in the US, it quickly reverted to lower levels. 

This underscores the fact that for the VIX to signal a credible recession threat, a sustained period of elevated levels is required when it spikes.

What would Beansprout do?

Based on what the VIX is telling us currently, concerns about a recession in the US this year are likely unwarranted. 

As such, there might be reason to stay invested to allow our savings to earn a return that exceeds inflation. 

For investors who would prefer to take a more passive approach to investing, we can consider investing in an ETF that offers diversified exposure to the US market such as a S&P 500 ETF.

Alternatively, we can also consider a global ETF, such as the VWRA ETF, which is popular choice amongst long term investors.