Higher Volatility and CEO Decision Making
Higher volatility is likely in four important asset markets. The end of quantitative expansion will drive a return to higher volatility in all these indices.
The global business world is nervously edging into a state of higher volatility and it is going to get even edgier over the next twelve months. With bets on higher market volatility, many are left wondering: what is driving this enhanced volatility, what executive decisions is it complicating and how can thoughtful CEOs anticipate and mitigate these risks?
Volatility is purely a measure of dispersion – of variation in price up and down in asset markets. Higher volatility does not necessarily imply anything about the direction of price movements, but higher volatility does unambiguously inject more risk into decisions being crafted in the C-Suite.
CEOs and CFOs are all looking down the gun barrel of higher volatility in four important asset markets that affect their businesses: the US Treasury 10 year yield; the benchmark “risk free rate” (RFR) against most financial assets are priced, as measured by the CBOE TYVIX index; foreign exchange rates, as reflected in the JP Morgan global FX volatility index (JPMVXYGL); U.S. equity prices as measured by the CBOE VIX index, which tracks dispersion in the S&P; and the price of oil as reflected in the CBOE crude oil volatility index (CBOE OIV).
In last year’s Teneo book, we predicted that the era of tamed volatility would shortly end, and we were right on the money. After a flat summer, both the OVX and the TYVIX started to pop in the fourth quarter of 2014, right after last year’s book went to press. The TY- VIX exhibited the highest intraday volatility since the 2009 financial crisis, and the OVX had its biggest jump since mid-2011. The JPM- VXYGL also woke up from its mid-summer slumber, during which it dipped to 5, and shot up to 10 at year end, its highest level since 2013. The VIX alone finished the year sedately, with its volatility dampened by the great S&P bull market of 2014. But that, too, is changing rapidly with the VIX zooming from 13 in mid-August to 28 in just two weeks.
The underlying driver of the return to higher volatility in all these indices is the end of quantitative easing (QE) on the part of the Federal Reserve Bank and the Bank of England (BOE) as well as the first hike in the federal funds rate, which will drag the risk free rate back up to historically normal levels. This normalization process is the trigger of greater volatility across the other asset classes. The vast pools of liquidity that central banks collectively poured into financial markets since the great financial crisis suppressed volatility for eight years running.
Exactly when and by how much the Fed will turn off the QE punchbowl and allow the RFR to return back up to normal levels has every portfolio manager on the planet scratching their head. What is clear, however, is that while the Fed and the BOE are turning off the QE spigots, the European Central Bank (ECB), the Bank of Japan (BOJ) and the People’s Bank of China (PBOC) will still be sluicing money into their respective financial markets: dubbed the “differential taper.”
How Risk is Amplified
Higher volatility amplifies the risk of a wide range of business decisions by CEOs. Examples include:
- Higher volatility in the TYVIX and the RFR means that the threshold rate of return for making strategic investment decisions, whether in terms of capital expenditure (CAPEX) or acquisitions, is also edging up. Wall Street analysts are rudely second-guessing CEO’s investment decisions and they will continue to get more aggressive about return on investment criteria. As the RFR goes up, institutional investors are desperate to take advantage of higher yields; they want commensurate returns from their equity portfolio or they want their money back. The differential taper (spigots off in U.S. and UK, spigots full on in Europe and east Asia) means that firms will face different costs of debt capital in different markets, making these investment decisions for firms with a global market footprint even more complex.
- Greater volatility in the JPMVXYGL and foreign exchange rates means that translating revenue and profit figures into the single currency (usually dollar) set of consolidated financial statements introduces greater variability in quarterly reporting, especially for firms with a regionally concentrated sales or production footprint. Since FX volatility will be highest among emerging markets, firms with revenue or production exposure in emerging markets (EM) will experience even greater volatility in reported performance, just as investors and analysts are ever-more-intently scrutinizing which firms meet (or miss) the quarterly EPS targets. The surprise 2 percent devaluation of China’s renminbi on August 11 is a harbinger of more volatility to come.
- Bigger gyrations in the VIX and equity prices is making the timing of stock repurchases very sensitive, and open to potential criticism by shareholders. In 2015, the S&P firms are collectively doing $600 billion worth of share repurchases on an annualized basis. CFOs may leave a lot of money on the table if they end up buying at peaks; investors won’t be happy about being bought out at valleys. If CFOs cut back on these share repurchases due to higher uncertainty associated with greater volatility across markets, this will further amplify volatility in the VIX, since share repurchases may be as responsible for the 2015 equity bull market as it was not sustained central bank liquidity.
- Higher volatility in the VIX and stock prices boost the ratio of beta (β) to alpha (α) in any given firm’s stock price. CEOs can legitimately claim some credit for a firm’s alpha, but virtually none for its beta, which is driven by overall market volatility. Beta related to overall market variation can wash out management’s alpha contribution in more volatile periods. This may make it harder for CEOs to justify their compensation packages and, in some cases, their own perch in the C-Suite.
- Higher equity volatility also makes M&A transactions trickier, especially those funded with stock. This means the daily market price of both firms will see-saw more wildly after an M&A decision has been made and its ratio of buying to acquiring stock has been fixed, leading shareholders on one side of the transaction to be more unhappy. Firms engaged in these transactions are being exposed to this kind of second-guessing as government authorities around the world are increasingly intrusive in asserting approval authority over M&A transactions, whether on competition policy grounds (in Europe and China) or on national security grounds (in the U.S.). These approvals prolong the time it takes to consummate an M&A transaction.
- Listed firms may become more vulnerable to hostile takeovers when they themselves are on the wrong side of a sudden downtick. The large pools of money being mobilized by activist funds mean that all but the largest market capitalization firms can be put in play. The choice of whether to resist or comply is both complicated and extremely time-consuming. A wrong decision can defenestrate the CEO.
Higher volatility in the OVX and energy prices makes it difficult to decide where to locate CAPEX. For example, petroleum or natural gas feedstock will vary more across borders and over time. This isn’t limited to industries like plastics: the economics of running a data center for an Amazon or a Google is most sensitive to the price of electricity. Big data centers absorb about 20 gigawatts annually. More variation in fuels costs means more variation in the cost basis and thus, the profit performance of a whole range of transportation industries, including airlines, trucks, railroads, and shipping.
How much more volatile could these four indices get in the next twelve months? The TYVIX at 5.1 in September is just a third of its peak during the financial crisis. If the TYVIX should return to its second highest peak in late 2011 of 10 in response to a normalized RFR (a sort of “taper tantrum” redux), that’s a twofold jump. Using the same reasoning, the JPMVXGL, at the 11 mark in September, would break through 17 if it rose to its second highest historical peak since the financial crisis. The VIX, just shy of 25 in September, would leap to 45, which was its second highest peak in late 2011. The OVX, at 45 in September, would hit 60, which was its second highest peak in late 2011. These are all big ranges.
So what does one do about this near-certain prospect of higher volatility as a CEO or CFO, other than hunker down? There are several ways to incorporate this into strategic thinking; here are a few examples:
- The taper trigger of higher volatility is so important in terms of the timing and scale of “the return of volatility” that even the CEOs of non-financial firms need to keep their eye on central bank policy. Central bankers deliberate and debate policy timing, including a taper, in technical terms, but it is a profoundly political decision, and the political vectors can be analyzed like any other high profile fiscal or monetary policy decision.
- When making big CAPEX or acquisition decisions or when modeling the profitability of these investments ex ante, it makes obvious sense to factor in a wider dispersion of assumptions with regard to interest burden, energy costs, and FX parity changes that can affect both revenue and costs.
- When the CEO and CFO translate the firm’s strategy into an investor relations narrative, whether for the quarterly earnings call, to explain an M&A decision, or to justify managerial succession, it is prudent to frankly acknowledge the higher risk environment that this volatility has engendered, and make explicit how management has factored higher volatility into these tough calls.
- Volatility is discontinuous, but it rarely comes out of the blue. Historically, big changes in volatility are preceded by smaller changes that are much larger than mean variation; in other words, a 3 sigma event is often preceded by a 2 sigma event. A number of models have been developed to estimate and predict financial volatility based on a mathematical approach known as generalized autoregressive conditional heteroskedasticity (GARCH). Some predictive analytic systems, such as Predata, sift digital and social media to extract digital conversations, are able to generate event predictions using GARCH-like models. Teneo Intelligence and Teneo Strategy’s digital offering can translate these models into useful early warnings for clients.
- The notional trigger for enhanced volatility in any one of these four indices is very likely to be an event that is knowable or at least trackable in advance, since bursts of volatility are often associated with high profile bilateral or multilateral meetings. Oil prices began their dramatic slide in late 2014 when an October OPEC meeting concluded with no agreement to reduce production quotas. This underlines the value of following a detailed risk event calendar - the sort that Teneo Intelligence uses to schedule its research and to regularly alert clients.