Financial Fear Factor: Has the Fiscal Cliff Been Priced In?

Have the capital markets “priced in” the fiscal cliff? Not yet. With the deadline to reach a deal quickly approaching, increased uncertainty could roil the markets. Investors have developed an index reflecting market uncertainty called the Volatility Index—it’s known on Wall Street as the “fear gauge.” This paper dissects the fear gauge and shows that even a short term failure to avert a fiscal cliff crisis could have a serious impact on the economy.

In the markets, there is no such thing as positive volatility. In 1993, investors developed a gauge—a market index—that reflects market uncertainty. It’s called the Volatility Index (VIX). Since the index came into existence, a relationship has been found between higher volatility and lower stock prices.

A Look Back at the S&P 500 and the Volatility Index¹

After months of negotiation, the failure by policymakers to reach a deal is already being felt. On December 12, The Associated Press reported that Federal Reserve Chairman Ben Bernanke explained, “Clearly the fiscal cliff is having effects on the economy.”²

Fear Itself

How do investors anticipate the direction of the economy? Investors on Wall Street are in constant communications with the people and institutions that move money around to get a sense of economic conditions on the ground. They are continually speaking to company management about plans for investments, hires, and sales. They speak frequently to banks about lending, credit availability, and consumer behavior. They talk to pension fund and endowment fund managers about their risk appetites and investment strategies. And they pour over data.

This serial gathering of information helps investors determine economic conditions; whether investors are optimistic or pessimistic going forward. Are they in a “risk on” or a “risk off” place? That is, do businesses and investors believe that it is the right time to invest, hire, and borrow, or should they hoard cash, conserve resources, and wait for better times?

Options—financial instruments that offer the right to buy or sell an asset in the future at a specific price—can be used by investors to hedge risk. The Chicago Board Option Exchange Volatility Index, also known as the VIX, is calculated by using the price investors are willing to pay for options tied to the S&P 500—an index of 500 companies representing a wide range of industries in the U.S. economy. The VIX can be used to deduce investor opinion about future market movement. The VIX also reflects investor sentiment about the volatility of the S&P 500 in the short term—specifically, over the next 30 days. If the VIX is 20, it means investors expect the S&P 500 to be 1.67% higher or lower over the next 30 days.³ The index value is determined by annualizing the 30 day expected volatility (1.67 x 12 months = 20).

Therefore, a high VIX means the expectation of a volatile and rollicking market; a low VIX means expectations of a steady and predictable market.

The VIX, 9/11, and the Debt Ceiling

During the 2008 financial crisis, the VIX reached levels close to 80, the highest on record.⁴ Investors were so fearful about the future economy that they felt the nation’s most important stock index could fall by close to 7% over the next 30 days. In actuality, the S&P 500 plunged 24% in the 30 days following the failure of Lehman Brothers on September 15, 2008, and fell over 43% before reaching its nadir on March 9, 2009.⁵ The VIX didn’t predict the future outcome, but it certainly anticipated significant volatility and a stock price collapse.

When the 9/11 attacks hit the twin towers and Washington, the VIX peaked at 49 in the days after the attack. When Congress nearly breached the debt ceiling in July 2011, the VIX peaked at 48.⁶ In other words, the threat of inaction by Congress spooked investors as much as history’s most lethal foreign attack on American soil—an attack that took place in the heart of the financial sector.

Of course, policymakers did not breach the debt ceiling. Investors and businesses were simply spooked by the brinksmanship in Washington. Nonetheless, many believe that the debt ceiling debacle set back our economic recovery. University of Michigan professor Betsey Stevenson and University of Pennsylvania professor Justin Wolfers found that consumer confidence collapsed around the time House Speaker John Boehner announced he would not support a debt ceiling extension on May 11, 2011. New job creation had averaged 207,000 through the first 4 months of 2011, but fell to 80,000 a month over the next 4 months as the debt ceiling fight escalated. Once policymakers averted default on July 31, 2011, job creation returned to its previous pace by September.⁷ The debt ceiling debate also convinced many investors that Washington is unable to meet even the most basic expectations of fiscal and economic competency.

Going off the Cliff

Now we approach the fiscal cliff and the discussion about whether a failure to prevent sequestration and across the board tax hikes—even for a short time—will impact markets and the economy in a big or small way. Like the debt ceiling debacle, investors know that this would be a totally self-inflicted wound. But that doesn’t soothe the markets, in fact it spooks them. In capital markets, uncertainty in the policy arena can lead to volatility. For example, in Europe the economic crisis is as much about the Eurozone’s perceived political inability to act as it is about the balance sheets of individual countries.

The concern is that as we inch toward the cliff, the VIX will rise. As we get close to the witching hour, investor confidence in Washington’s ability to resolve the fiscal cliff will likely sink further—sending the VIX higher and stocks lower. And since we didn’t actually breach the debt ceiling in 2011, if we go over the cliff there is a greater chance of steeply falling stock prices, less confidence, and an economic slowdown—even if it’s only a short trip off the cliff.

The chart that follows shows volatility in markets since 1990 and the events often credited for causing spikes. When the VIX is low; stocks generally rise. And when the VIX is high, stocks generally fall. It is rare when falling stock prices signal anything good about the economy. From 1990 to 2008, the average value has been 19.⁸

A Look Back at the S&P 500 and the Volatility Index⁹

Many are asking if capital markets have “priced in” the fiscal cliff. And the answer is not yet. Since November 1, the VIX has remained basically steady around historical averages.

In October, Bank of America determined that only between $40 and $80 billion of fiscal tightening has been factored into 10-year Treasury bonds out of a total of $325 billion in likely budget cuts under sequestration.¹⁰ A BlackRock report highlighted how investors had:

Not priced for the possibility of a ‘fiscal cliff’…and financial markets do not appear to be bracing for such a big risk event. The S&P 500 index is close to record highs and volatility is eerily low. Our conclusion: Markets have not priced in the ‘fiscal cliff’ and assume QE (Quantitative Easing) 3 will drown out other factors. ¹¹

As recently as December 9th, USA Today reported that according to Alec Young, an international analyst for Standard & Poor’s, “The markets are assuming that a deal is still likely to save the day. If they thought nothing would be done, the markets would sell off badly.”¹² Jeffrey Gundlach, a portfolio manager and CEO at the Los Angeles bond management firm DoubleLine, indicated that, “people believe that there’s already a secret deal that will be put through at the 11th hour.”¹³

Recent Activity on the Volatility Index¹⁴

But what if markets are wrong and we dive off the cliff? Scott Nations, CIO and President of Chicago-based NationShares, explains that, “The potential exists for a serious problem, if we get into the first part of the year and into the middle of January without some sort of [fiscal cliff] resolution.”¹⁵ Bank of America warns that the S&P 500 could fall to 1,000, levels not seen since the financial crisis.¹⁶

Conclusion

Washington policymakers shouldn’t be slaves to the market, but they should be aware of them. In the remaining weeks of the year, as we approach the fiscal cliff, it is likely that as high-level negotiations are conducted it will look on the outside like chaos. Investors currently expect a deal to get done. But that sentiment could quickly change as the deadline draws even nearer; leading to increased volatility and uncertainty that could roil the market and tamp the brakes on the economy.

If that is the price it takes to negotiate a balanced deal, it will be worth it. But a failure to get a deal likely means failure in the market—at least in the short term. And that can lead to a slowdown in the real economy. However, should Congress succeed in passing a major budget deal, Bank of America predicts the S&P 500 to climb as high as 1,500.¹⁷ And if history is a good predictor of the future, higher stock prices usually presage a stronger American economy.

Given the possibilities, Congress should come together and forge a balanced deal that averts the fiscal cliff.